The Property, Plant and Equipment (PPE) classification is shown on the Statement of Financial Position/Balance Sheet under Non-Current Assets. Non-current assets are assets that are intended to be held for longer than one year. PPE includes fixed assets that the entity uses for the production of goods and/or rendering of services. Examples of PPE include: machinery, vehicles, buildings, computers, and office equipment.
In this article, we review the basics of PPE: how we define PPE, what is included in the costs of PPE, how we eventually convert PPE into an expense and how we present PPE in our financial statements. We will discuss more complex concepts in our next articles - so stay tuned!
Definition
IFRS (standards used by public companies) defines PPE differently than ASPE (used by private enterprises in Canada).
IFRS
IAS 16 defines PPE as tangible items that:
Are being used for the production of goods and/or services. This includes rental property and property that is being used for administrative purposes. AND
Are expected to the held for longer than one fiscal year.
ASPE
ASPE 3061 defines PPE as tangible items that are identifiable, and meet all of the criteria listed below:
Are being used for the production of goods and/or services. This includes rental property and property that is being used for administrative purposes. AND
Were acquired, purchased or built with the intention of using the assets for business purposes. AND
Has not been acquired or constructed with the intention of being sold.
To summarize both standards together - PPE includes tangible assets that are being used for business purposes, are intended to be held for more than one fiscal year and are not procured or built with the intention of being sold.
Concept of Capitalization
Before we delve into the cost of PPE, it is important to understand capitalization and how this differs from expensing.
When a change is made to PPE that improves the asset by extending the life or improving the quality, this is considered a “betterment”. Betterments typically improve output, lower running costs in the future, help to bring in more revenue or may be required for continued operations (for example: the installation of safety railings). When an entity pays for a betterment, that cost is capitalized into PPE - meaning it is added as an asset in PPE, instead of being expensed.
So instead of doing this:
We will need to do this:
The first journal entry would have added the railing equipment to the Income Statement under the Expense category. This is not the correct method of recognizing the railing equipment.
The second entry correctly shows the railing system as part of equipment within the PPE category. This will show up on the Statement of Financial Position/Balance Sheet as an asset.
The reason we capitalize assets instead of expensing them, is because we need to recognize expenses in the periods in which they are incurred. While cash may have been paid in one period, the expense must be recognized in the period in which the item is used. For assets that last longer than a year, capitalization provides us with a method to ensure that we recognize an expense for each year the asset is in use - instead of all at once. We discuss how to convert the capitalized asset into an Expense in the sections below. But first, let’s talk about what we should capitalize.
What is included in the Cost of PPE?
Our next step is to identify what is included in the cost PPE (a.k.a “capitalized”). While it is fairly obvious that the purchase price of PPE should be included in its cost, there are other costs associated with PPE that are less obvious.
When initially recognized, the cost of PPE should include the following:
Purchase price,
Import duties LESS discounts and rebates,
Any costs directly related to bringing the asset to the location and condition required for use,
Cost of site preparation,
Initial delivery to the site and handling,
Installation costs,
Professional fees (legal, architectural),
Testing costs LESS any proceeds from the sale,
Shipping costs,
Non-recoverable portion of sales tax (eg: if HST is recoverable, then it is not capitalized),
Borrowing Costs when the PPE is being constructed (required for IFRS, optional for ASPE),
Decommissioning costs.
Borrowing Costs
Entities will often borrow money to fund their capital projects.
ASPE
Under ASPE, entities are not required to capitalize borrowings, they may expense them instead. This is a choice made by the entity. If an entity does choose to capitalize borrowing costs, they must use the same procedures as used for IFRS, explained below.
IFRS
Interest Costs attributable to the acquisition, construction or production of the asset should be capitalized. IAS 23 (IFRS) explicitly requires that borrowing costs for a qualifying asset, that are directly attributable to the construction, acquisition or production be capitalized. A qualifying asset is an asset that takes time to be ready for its intended use or sale (eg: wine, buildings, etc..). If we borrow money to build a manufacturing plant, we need to capitalize the interest incurred on the borrowed amount up until the plant is finished.
Capitalization of the interest costs should start when expenditures on the asset start and the borrowing costs start, and cease the moment the asset is ready for its intended use. In other words, if we are building PPE, any borrowing costs/interest costs and construction costs are capitalized during the construction process, until the PPE is ready for use (or 90% of it is being used). We should also suspend capitalizing borrowing costs during periods of inactivity. For example, if we are constructing a plant and there is a 6-month worker’s strike that results in no further construction activity during those 6 months, instead of capitalizing those costs, we should be expensing them during those 6-months.
How to calculate borrowing costs:
If there is only one asset-specific loan that is used to produce the PPE, then we should use that interest amount to capitalize into that specific asset.
For example, let’s assume we have two capital projects for being constructed during the fiscal year. One project involves building an office space, which will cost $100,000. We borrowed the full amount specifically for this project at an interest rate of 5%. Assuming the full loan amount was outstanding for the full fiscal year, we will have paid an interest charge of:
5% x $100,000 = $5,000
This amount will be capitalized into the “Office” asset.
However, often entities will borrow money for a variety of different projects (some capital and some operational) and from a variety of different sources. If a mixture of instruments has been used to fund the project, we should use the weighted average interest rate.
Continuing with our earlier example, the other capital project is a $2,000,000 manufacturing plant, started 1 month before year end. During this 1 month, only $100,000 of costs were incurred. This plant had no specific borrowings associated with it. However, the company did use money from a bank loan and bonds to build the plant. Because there are no asset specific borrowings, we will need to use the weighted average interest rate of the loan and bonds.
The terms of the bank loan and bonds are as follows:
Bank loan of 7%, $10,000,000 outstanding all year
Bonds at 4%, $15,000,000 issued on August 01
Assuming a year end of December 31, the calculations for the weighted average interest rate at year end would be as follows.
Numerator Calculation: Total Interest Paid for the Year
($10,000,000 x 12/12 x 7%) + ($15,000,000 x 5/12 x 4%) = $950,000
Note that we are interested in the period for which we are accruing interest. Since the bank loan was outstanding all year, the number of months of interest accrued is 12, while the bonds only started accruing interest on August 01, so there were only 5 months of interest accrued.
Denominator Calculation: Weighted Average Loan Outstanding for the Year
($10,000,000 x 12/12) + ($15,000,000 x 5/12) = $16,250,000
Weighted Average Interest Rate:
$950,000 / $16,250,000 = 5.85%
Note: Only interest that has been paid should be capitalized. Accrued interest, which has not yet been paid, should not be capitalized.
Returning back to our plant project... to calculate the amount of borrowings to be capitalized into the plant, we simply multiply the weighted average interest rate by the construction costs incurred to date.
The amount to be capitalized would be calculated as:
5.85% x $100,000 = $5,850.
Summary of steps for calculating capitalized borrowings:
For asset specific borrowings, capitalize the interest cost for that specific asset, using the specified borrowing rate, first. If the asset-specific borrowings do not fully cover the cost to build the asset: first apply asset-specific borrowings (as described above) to the portion that is covered, then proceed to step 2 and onward, below.
For the remaining assets (or remaining amount of an asset), which are funded through general company borrowings, calculate weighted average interest rate applied to general borrowings. Do not include the asset-specific interest in this calculation.
Apply the weighted average borrowing rate to the remainder of the asset costs incurred during that period.
Decommissioning Costs
Decommissioning costs are the costs associated with dismantling, withdrawing, removing and/or remediating the plant, property or equipment in the future. For example, if a manufacturing plant requires dismantling and environmental remediation in the future, IFRS outlines that these costs should be capitalized into the cost of the property. In order to calculate decommissioning costs, we will need to find the present value of the estimated future costs and add this to the asset cost. This will also create a liability for the entity.
Note that decommissioning costs do not need to be capitalized under ASPE. We are only required to capitalize decommissioning costs if there is an existing contractual obligation to decommission. If there is no contractual obligation, ASPE 3061 allows us to expense the costs when they are incurred.
To best illustrate how to recognize decommissioning costs, we will review the associated journal entries.
Let’s assume we purchased a building to be used for manufacturing purposes. The building purchase price and all associated fees, cost the company $200,000. The present value of the decommissioning costs is best estimated at $50,000.
Upon initial recognition, the journal entry for the building would look like this:
What is not included in PPE, when initially recognized?
Let’s move onto clarify what costs are not to be capitalized into PPE.
Expenses that are not included in the cost of PPE include:
Administrative and general overhead
Staff training
Celebratory costs
Any costs related to introducing the new product
Repair Costs after the PPE is put into use
These costs should be listed as expenses and added to the Income Statement. They should not included as assets on the Statement of Financial Position/Balance Sheet.
Depreciation
Since PPE is capitalized and not expensed, companies need to be given a means to deduct the asset from its revenues, over the useful life of the asset. This is done through depreciation / amortization (IFRS uses the term “depreciation” while ASPE often uses the term “amortization”). Depreciation is a means by which we convert a capitalized asset into an expense, and slowly deduct it from our revenues. Depreciation happens because, over time, the PPE item will likely be less usefulness to the company, as it degrades, and eventually requires decommissioning.
There are a few important definitions to understand before we get into the weeds of depreciation:
Fair Value: is defined as the market value of the asset - the amount that would be received if the asset were to be sold today to an arm’s length buyer.
Residual Value: is defined as the amount that the entity will expect to receive if they sold the asset at the end of its useful life. This can also be referred to as the scrap value or resale value.
Net Book Value (NBV): is defined as the value of the asset, after deducting depreciation and any impairments.
Now, back to our discussion…..
Depreciation occurs, even if the Fair Value of the asset is greater than the Net Book value. In other words - even if we could technically sell the asset for more than its net value (on our books), we should still deduct depreciation. For example, if we have a building that increases in value as land prices increase, we should still deduct depreciation on that building.
Depreciation continues to be recognized for as long as the Net Book Value is greater than the Residual Value.
Depreciation starts to accumulate when the asset is available to start use, and stops when:
The asset is derecognized, OR
Classified as held for sale, whichever comes first
Depreciation does not stop when the asset is idle, unless depreciation uses the Units of Production method, which we discuss below.
Depreciation is also based on the total PPE value. This includes all of the costs initially capitalized into the property.
3 Methods for Calculating Depreciation
There are 3 acceptable methods for calculating depreciation.
Straight Line Method:
Depreciation per year = (Purchase Cost - Residual)/Useful Life
Units of Production Method:
Depreciation per year = (Purchase Cost - Residual)/Total life units
Diminishing/Declining Balance Method:
With this method we deduct a certain percentage every period. The new depreciation expense is based on a smaller balance than the previous one, as the balance diminishes over time.
NBV @ end of year X = original cost x (1-depreciation rate)^x
For example, if we have a building worth $100,000 that depreciates at 4% each year, the first year depreciation would be: $100,000 x 4% = 4,000. The Net Book Value at the end of the first year would be: $100,000 x (1-0.04)^1 = $96,000. In the second year, we would have a depreciation of: $96,000 x 4% = $3,840. And so on…
Changes in Depreciation Estimates
Sometimes, depreciation estimates may change.
Changes in useful life should be recognized immediately, and a new depreciation expense should be calculated for the remaining years, based on the remaining NBV.
Changes in residual value should be recognized immediately, and a new depreciation expense should be calculated for the remaining years, based on the remaining NBV.
How to Record Depreciation Expense and Decommissioning Costs
The journal entry for a depreciation expense may look something like this:
The “Accumulated Depreciation” account is a counter-asset account. It is simply there to keep track of the total Accumulated Depreciation for each asset, individually. Each asset account will have its own Accumulated Depreciation account, hence “Acc. Dep. - Asset A” and “Acc. Dep. - Asset B” are presented separately. This is then netted from the specific asset accounts when creating our financial statements. On the other hand, the Depreciation Expense account is usually a general account that adds all of the Accumulated Depreciation expenses from all assets, together. The Depreciation Expense is shown as a total expense in the Income Statement.
Total Accumulated Depreciation cannot exceed the cost of the asset. If it is completely depreciated, then no further depreciation should be charged, and the asset remains at 0 Net Book Value.
Land is generally not depreciated as it is considered to have an unlimited lifespan. There are exceptions with mining companies, and other entities which physically degrade the land. The building on the land can be depreciated. While land might increase in value, it does not necessarily mean that the building, which sits on the land, increases in value.
Let’s now combine both depreciation and asset retirement obligations. Assuming we have a building - Building A - that both depreciates over time, and has an asset retirement obligation, our journal entry after Year 1 might look something like this:
After Year 1:
*Remember that since we have discounted the Retirement Obligation to its PV, we need to add the yearly amortization to this obligation, using the given discount rate, until we reach the full future value. This is similar to the Amortization Schedule found in our Notes Receivable Calculations article.
Presentation of PPE
PPE appears in the Balance Sheet on the Financial Statements, and should be divided into its major subcategories.
When PPE is presented on the financial statements, it is presented net of accumulated depreciation.
PPE is capitalized - meaning that the cost of the property is not deducted as an expense, but rather booked as an asset in the Balance Sheet. Certain costs associated with the PPE are also capitalized instead of expensed.
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