Common errors when accounting for property, plant and equipment (IAS 16 and PBE IPSAS 17 – Part 3)

Even though IAS 16 Property, Plant and Equipment (“IAS 16”), for Tier 1 and Tier 2 for-profit entities, and PBE IPSAS 17 Property, Plant and Equipment (“PBE IPSAS 17”), for Tier 1 and Tier 2 public benefit entities (“PBEs”), are relatively simple standards to read and apply, they are standards where preparers can easily make errors which affect the amounts recognised as property, plant and equipment (“PPE”) in the statement of financial position.
Our April Accounting Alert article identified errors relating to the scope of IAS 16 and PBE IPSAS 17, and our May article highlighted errors in relation to measurement at cost or revalued amounts.
This month we continue with IAS 16 and PBE IPSAS 17 and look at typical mistakes made when calculating depreciation.

Error 1 – Assuming useful life is the total economic life (potential life) of the asset

Useful life is:

The period over which an asset is expected to be available for use by an entity, or
The number of production or similar units expected to be obtained from the asset by an entity.

Definition of “useful life” in IAS 16 and PBE IPSAS 17

A common error is to assume that the useful life of an asset equals its economic life.

Example

ABC Limited acquires a motor vehicle to be used by its sales director for $40,000.
It estimates that the vehicle has the potential to stay on the road for eight years, but only intends to use it for three years, at which point its fair value is expected to be $19,000.
In this case, the useful life of the vehicle for depreciation purposes is three years because this is the period during which ABC Limited expects it to be available for use, and not eight years (which is its economic/potential life).
The annual depreciation charge is calculated as follows:

	$
Total cost	40,000
Less: Residual value	(19,000)
Depreciable amount	21,000
Useful life	3 years
Annual depreciation charge ($21,000/3)	$7,000

Error 1

Assigning a ‘useful life’ to an asset that is more akin to its economic life than the period that it will be available for use by the entity.

Error 2 – Ignoring legal limits on the use of the asset when estimating the useful life

When assigning a useful life to an item of PPE, IAS 16, paragraph 56(d) (PBE IPSAS 17, paragraph 72 (d)) requires that we consider any legal limits on the use of the asset, such as where the entity enters into a lease for premises and installs leasehold improvements with economic/potential lives that exceed the lease period.

The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economic benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset:
(a) expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output.
(b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle.
(c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset. Expected future reductions in the selling price of an item that was produced using an asset could indicate the expectation of technical or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.
(d) legal or similar limits on the use of the asset, such as the expiry dates of related leases.
IAS 16, paragraph 56 and PBE IPSAS 17, paragraph 72 (note that, where IAS 16 uses the term “economic benefits”, PBE IPSAS 17 uses the term “economic benefits or service potential”).

IAS 17 Leases, paragraph 27, and PBE IPSAS 13 Leases, paragraph 36, also require that finance leased assets on the books of lessees be depreciated over the shorter of the lease term and useful life.
A common error is to ignore legal limitations and incorrectly depreciate assets over the longer economic life, rather than the shorter lease period. Another one is to not factor in the chances of exercising lease extension options when determining useful lives of assets.

Example

Retail Co enters into a five-year lease with Shopping Centre Co to occupy Shop 35 in the City Centre Shopping Mall.
Retail Co spends $300,000 on leasehold improvements for its store. These improvements cannot easily be moved at the end of the lease. It is estimated that these improvements could be used for seven years if they remain on the same site.

Although the economic life of the improvements is 7 years, the legal limitations on using the improvements is 5 years because the improvements cannot easily be moved at the end of the five- year lease. Therefore, Retail Co would depreciate leasehold improvements over the lease period, and not the longer economic life.
However, if Retail Co has an option to extend the lease by two years, and it is reasonably certain that it will exercise this option, the leasehold improvements could be depreciated over the seven- year period. However, such a call requires judgement. "Reasonably certain" is a fairly high threshold to meet and Retail Co would need to take into account factors such as:

How much it would cost to move premises for the additional two years
Rent costs for the option period compared to expected market rentals, and
Significance of the premises/position to its business model.

Error 2

Ignoring legal limits, including on leases, when determining useful lives of assets.

Error 3 – Assuming useful life or depreciation rate is always the same as that allowed by the tax authorities for tax depreciation

As noted in Error 1 above, the depreciable amount of an asset with a finite useful life is depreciated on a systematic basis over its useful life (IAS 16, paragraph 50 and PBE IPSAS 17, paragraph 66).
Many tax authorities publish acceptable tax depreciation rates as a short cut method for entities to determine taxable income. These tax depreciation rates may not always be indicative of the useful lives of assets for accounting purposes.

Many entities unquestioningly use these published tax depreciation rates for accounting depreciation, ensuring that no deferred tax entries are needed because there are no temporary differences between the accounting and tax depreciation charges. However, this is a common error if the tax depreciation rate is not a fair reflection of the useful life of the asset to the entity.

Error 3

Unquestioningly accepting published tax depreciation rates for accounting purposes without further analysis.

Error 4 – Getting the residual value wrong when determining the depreciable amount of an item of PPE

The basic requirement in IAS 16 and PBE IPSAS 17 is that the depreciable amount of an asset with a finite useful life is depreciated on a systematic basis over its useful life (IAS 16, paragraph 50; PBE IPSAS 17, paragraph 66). Depreciable amount is the cost (or fair value if the revaluation model is applied) less residual value.

Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.
Definition of “depreciable amount” in IAS 16 and PBE IPSAS 17
The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.
Definition of “residual value” in IAS 16 and PBE IPSAS 17

Another common error is to either inflate the residual value so as to reduce the amount of annual depreciation, or conversely to assume a very nominal or zero residual value such that the annual depreciation amount is inflated, resulting in a large profit when the asset is sold.
It should be noted regarding residual value that:

Estimated disposal costs need to be deducted (resulting in a lower residual value and higher depreciation charge), and
We must assume that the asset is already used, and in the condition we intend to sell it in in X years’ time (also resulting in a lower residual value and higher depreciation charge).

Example

On 1 January 2018, DEF Limited acquires a brand new Toyota Corolla for $30,000. It intends to use the car for three years. The second hand value of a 2018 Toyota Corolla is $25,000. The second hand value of a 2015 Toyota Corolla is $18,000.
It would be incorrect for DEF Limited to use $25,000 as residual value because this reflects the condition of the vehicle as new.
If the outlook for new and used car prices is not expected to change significantly over the next three years, it may be appropriate for DEF Limited to use the $18,000 three-year second hand car price for a 2015 vehicle as the residual value. This is because the price for a 2015 (three-year old) vehicle could be an indicator of the amount DEF Limited would be able to sell the car for in 2021, when it has been used for three years.

Error 4

Failing to assume (and estimate) the asset is of the age, and in the condition, expected at the end of its useful life.

Error 5 – Failing to update assessment of useful lives, depreciation rates, and residual values

The residual value and the useful life of an asset shall be reviewed at least at each financial year-end…
Extract of IAS 16, paragraph 51
The residual value and the useful life of an asset shall be reviewed at least at each annual reporting date…
Extract of PBE IPSAS 17, paragraph 67

However, many preparers forget to review the residual values and useful lives of PPE assets at the end of each year to determine if they are different from previous estimates. This assessment needs to occur for all assets, at least at the end of each financial year.

The words “at least at each financial year-end”/ "at least at each annual reporting date” imply that this review should take place more often if there are indicators during the year that the residual value or useful life of an asset has changed.

Failing to reassess useful lives and residual values each year could result in the depreciation charge being materially over or understated in certain periods.

Error 5

Not reviewing the useful lives and residual values of all assets at the end of each financial year.

Error 6 – Accounting for changes to residual values and useful lives of assets as a change in accounting policy

Following on from Error 5 above, if you review residual values and useful lives of assets and decide that some changes are needed, the question then is how to account for these changes.

The residual value and the useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
IAS 16, paragraph 51
The residual value and the useful life of an asset shall be reviewed at least at each annual reporting date and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with PBE IPSAS 3 Accounting Policies, Changes in Accounting Estimates and Errors.
PBE IPSAS 17, paragraph 67

IAS 16 and PBE IPSAS 17 explicitly require changes in useful lives and residual values to be accounted for as a change in estimate under IAS 8/PBE IPSAS 3 (i.e. adjustments are made prospectively on a going forward basis). No adjustments are made to prior periods.

Error 6

Failing to account for changes to residual values and useful lives of PPE as a change in accounting estimate as per IAS 8/PBE IPSAS 3.

Error 7 – Relationship between impairment and useful lives and residual values

Following on from Error 5 above, residual values of assets and useful lives must be reassessed at the end of the financial year. IAS 16, paragraph 56, and PBE IPSAS 17, paragraph 72, outline factors to be considered when determining useful life.

expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output.
expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle.
technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset. Expected future reductions in the selling price of an item that was produced using an asset could indicate the expectation of technical or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.
legal or similar limits on the use of the asset, such as the expiry dates of related leases.

IAS 16, paragraph 56; PBE IPSAS 17, paragraph 72 (note that the above is extracted from IAS 16; the PBE IPSAS 17 paragraph is essentially identical, but where IAS 16 refers to “economic benefits”, PBE IPSAS 17 refers to “economic benefits or service potential”)

Where, for example, production machinery is expected to be obsolete in say three years, the useful life of the machinery would be reduced to three years.
A common error occurs when management assumes that because it has adjusted the useful life, no further impairment assessment is necessary.

Example

Production Co has machinery (carrying amount of $1 million) to manufacture DVDs. Research shows that DVDs will be obsolete in five years’ time. The useful life of the machinery is currently estimated to be 10 years.
After reducing the useful life from 10 years to five, the annual depreciation charge will increase from $100,000 per year to $200,000 per year (refer Error 6 above – account for changes prospectively as a change in estimate under IAS 8/PBE IPSAS 3).
However, if the recoverable amount of the machinery today is less than $1 million, an impairment write-down is also required under IAS 36 Impairment of Assets/PBE IPSAS 26 Impairment of Cash-Generating Assets (or PBE IPSAS 21 Impairment of Non-Cash-Generating Assets, if applicable).

Error 7

Not impairing assets because useful lives and residual values have already been adjusted.

Next month

Next month, our common error series continues, with more errors when depreciating PPE.

For more on the above, please contact your local BDO representative.