Common errors when accounting for property, plant and equipment (NZ IAS 16 and PBE IPSAS 17)
In 2018 we continue our successful "common errors" series, this month highlighting some common errors when accounting for property, plant and equipment (PPE) in the entity’s financial statements. For Tier 1 and Tier 2 for profit entities, NZ IAS 16 Property, Plant and Equipment is the accounting standard which sets out the key principles for recognising and measuring PPE. For Tier 1 and Tier 2 Public Benefit Entities (PBEs), the equivalent standard is PBE IPSAS 17 Property, Plant and Equipment. While PPE may not be a material item on the balance sheet for service entities, it is often a significant item for entities owning land and buildings, those using heavy machinery and equipment such as manufacturers, explorers and construction businesses, those with significant CAPEX such as for store fit-outs, as well as agricultural producers with bearer plants.
Although the requirements of NZ IAS 16 and PBE IPSAS 17 are not particularly complex, there are nevertheless a number of areas where preparers make common mistakes, and these fall into the following four main categories:
- Scope - Accounting for items as PPE when they are not PPE
- What is ‘cost’?
- The revaluation model
This month we focus on nine common errors relating to the scope of NZ IAS 16 and PBE IPSAS 17, as well as common errors regarding what can and cannot be included as part of the ‘cost’ of an item of PPE.
Common error 1 – Accounting for items as PPE which are not within the scope of NZ IAS 16 or PBE IPSAS 17
NZ IAS 16 (or PBE IPSAS 17 for PBEs) applies to the accounting for ‘property, plant and equipment’ (PPE) which are defined as tangible items that are:
- Held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and
- Expected to be used during more than one period.
However, the following items are not PPE, and are excluded from the scope of NZ IAS 16 (PBE IPSAS 17):
||Accounted for under other standards
||NZ IAS 40 Investment Property (PBE IPSAS 16 Investment Property)
|Biological assets related to agricultural activity (other than bearer plants)
||NZ IAS 41 Agriculture (PBE IPSAS 27 Agriculture)
|Exploration and evaluation assets
||NZ IFRS 6 Exploration for and Evaluation of Mineral Resources
While the above mentioned items may meet the definition of PPE because they are held for use in the production or supply of goods or services over a period of more than 12 months (e.g. investment properties and biological assets such as sheep used to produce wool), a common error is to measure them under NZ IAS 16 (PBE IPSAS 17), rather than the specific standards specified above. This could result in entities incorrectly recognising, for example:
- Investment property fair value movements in other comprehensive income (other comprehensive revenue and expense) rather than profit or loss (surplus or deficit), masking earnings volatility for certain property companies, and
- Biological assets such as sheep or cattle at cost when the relevant standard, NZ IAS 41 (PBE IPSAS 27) requires measurement at ‘fair value less costs to sell’.
Common error 1
Applying the wrong accounting standard to account for items of PPE that are scoped out of NZ IAS 16 (PBE IPSAS 17).
Common error 2 – Bearer plants accounted for as biological assets
NZ IAS 41 (PBE IPSAS 27) applies to ‘biological assets’ which are living animals or plants. Certain items meet the definition of a ‘biological asset’ but are considered ‘bearer plants’ and therefore accounted for as PPE under NZ IAS 16 (PBE IPSAS 17).
A bearer plant is a living plant that:
- is used in the production or supply of agricultural produce
- is expected to bear produce for more than one period, and
- has a remote likelihood of being sold as agricultural produce, except for incidental scrap sales.
NZ IAS 16 (PBE IPSAS 17) - Definition of ‘bearer plant’
A common error occurs when entities fail to split up the bearer plant (e.g. fruit tree) and the agricultural produce growing on it (e.g. apples). If the bearer plant is not mature, in some cases this could distort earnings because the combined asset (including the bearer plant) is measured at fair value through profit or loss, rather than the bearer plant being measured at fair value through other comprehensive income, or at cost less accumulated depreciation.
Common error 2
Classifying bearer plants as biological assets and measuring them at ‘fair value less costs to sell’, instead of as PPE using the ‘cost’ or ‘revaluation’ model in NZ IAS 16 (PBE IPSAS 17).
Common error 3 – All plants accounted for as bearer plants
NZ IAS 16, paragraph 3(b) (PBE IPSAS 17, paragraph 6(b)) is clear that it is only bearer plants, and not all plants, that are accounted for as PPE. This means that the following are not bearer plants, and therefore should be accounted for at ‘fair value less costs to sell’ under NZ IAS 41 (PBE IPSAS 27):
- Trees in a timber plantation grown for use as lumber
- Annual crops such as maize and wheat, and
- Where there is more than a remote likelihood of selling the plant upon which the produce grows for an amount greater than scrap value.
Common error 3
Accounting for all plants as bearer plants as PPE under NZ IAS 16 (IPSAS 17), instead of as biological assets under NZ IAS 41 (PBE IPSAS 27).
Common error 4 – Bearer ‘animals’ treated as bearer plants
Following on from common error 2 above, bearer plants are accounted for under NZ IAS 16 (PBE IPSAS 17). That is, they are used in the production or supply of agricultural produce, they are expected to bear produce for more than one period, and there is a remote likelihood of selling the plant itself as agricultural produce.
Some preparers of financial statements mistakenly apply these requirements ‘by analogy’ to animals (using sheep as an example), on the basis that:
- Sheep are used in the production of agricultural produce (wool)
- They are expected to bear produce for more than one period, and
- There is a remote likelihood of selling the sheep as agricultural produce, except when they are old and die (as an incidental sale).
This amendment was not intended to be applied by analogy to other situations because it was a narrow scope amendment to NZ IAS 16 (PBE IPSAS 17), mainly to relieve owners of palm oil plantations in countries such as Malaysia from having to measure bearer plants such as palm trees at fair value.
Common error 4
Accounting for animals with features similar to bearer plants as PPE.
Common error 5 – Treating spare parts, stand-by and servicing equipment as inventory
Many preparers incorrectly assume that spare parts, stand-by equipment and servicing equipment are automatically accounted for as inventory, and expensed when they are used.
NZ IAS 16, paragraph 8 (PBE IPSAS 17, paragraph 17) notes that such items are recognised as PPE when they meet the definition of PPE. Otherwise, they are classified as inventory. This suggests that the default classification is PPE unless proven otherwise.
Where these items are only expected to be used during one period (say for less than 12 months), they should be classified as inventory. If they are expected to be used during more than one period, they should be classified as PPE and depreciated accordingly.
Common error 5
Assuming all spare parts and stand-by and servicing equipment are inventories.
Common error 6 – Capitalising costs incurred after the asset is capable of operating in the manner intended by management (start-up costs and initial operating losses)
NZ IAS 16, paragraph 15 (PBE IPSAS 17, paragraph 26) requires items of PPE to be initially measured at ‘cost’, which includes the purchase price and various other costs (refer extract of NZ IAS 16, paragraph 16 (PBE IPSAS 17, paragraph 30) below), but only those direct costs incurred until the asset is in the location and condition such that it can be used as management intended (NZ IAS 16, paragraph 20 (PBE IPSAS 17, paragraph 34)).
The cost of an item of property, plant and equipment comprises:
- its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
- any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable 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 is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.
NZ IAS 16, paragraph 16 (PBE IPSAS 17, paragraph 30)
Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management. Therefore, costs incurred in using or redeploying an item are not included in the carrying amount of that item. For example, the following costs are not included in the carrying amount of an item of property, plant and equipment:
- costs incurred while an item capable of operating in the manner intended by management has yet to be brought into use or is operated at less than full capacity
- initial operating losses, such as those incurred while demand for the item’s output builds up, and
- costs of relocating or reorganising part or all of an entity’s operations.
NZ IAS 16, paragraph 20 (PBE IPSAS 17, paragraph 34)
A common error is to misjudge the timing that an asset becomes available for use (i.e. capable of operating in the manner intended by management), and continue to capitalise costs after this date, for example:
- Start-up costs when asset is yet to be brought into use or is operating at less than full capacity
- Initial operating losses as demand for a product builds up, and
- Costs of subsequent redeployment of an asset.
Common error 6
Failing to have a formal ‘drop dead’ or practical completion date to indicate when an item of PPE is capable of operating in the manner intended by management.
Common error 7 – Failing to capitalise borrowing costs on self-constructed qualifying assets (for-profit entities only)
The current version of NZ IAS 23 Borrowing Costs has been in effect since January 2009, however many people think they still have a choice whether to capitalise interest when a qualifying asset is being constructed. NZ IAS 23, paragraph 8, requires borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset, to be capitalised.
There is no choice!
Common error 7
Expensing borrowing costs incurred when constructing a qualifying asset.
(The equivalent PBE standard relating to borrowing costs, PBE IPSAS 5 Borrowing Costs, has a benchmark accounting treatment of expensing all borrowing costs when incurred. PBE entities may instead elect to apply the allowed alternative treatment of capitalising borrowing costs on qualifying assets if they choose to do so under PBE IPSAS 5, but it is not compulsory as it is for for-profit entities).
Common error 8 – Ceasing capitalisation of borrowing costs too late (for-profit entities)
At the opposite end of the spectrum to common error 8 above, some entities continue to capitalise borrowing costs on self-constructed qualifying assets beyond the time permitted by NZ IAS 23, paragraph 22, which is when ‘substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.’
Common errors include capitalising borrowing costs when:
- The asset is complete but is not yet being used, or
- The asset is complete but there has been a delay in the sale process.
Common error 8
Continuing to capitalise borrowing costs after the qualifying asset is ready to be used or sold.
Common error 9 – Not reducing the cost of PPE for the effect of deferred payment terms
Another common error occurs when preparers fail to realise that the ‘cost’ of PPE acquired on deferred payment terms is not the same as the ‘cost’ when the purchase price of the asset is paid immediately. The supplier has effectively provided a loan to the buyer for the cost of the asset which, in an arm’s length transaction, would be expected to attract interest charges at market rates.
NZ IAS 16, paragraph 23 (PBE IPSAS 17, paragraph 37) clarifies that ‘cost’ of an item of PPE is the ‘cash price equivalent’ at initial recognition, with the difference being recognised as interest expense over the credit period (or capitalised under NZ IAS 23 (PBE IPSAS 5)).
The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognised as interest over the period of credit unless such interest is capitalised in accordance with NZ IAS 23 (PBE IPSAS 5).
NZ IAS 16, paragraph 23 (PBE IPSAS 17, paragraph 37)
Common error 9
Failing to reduce the cost of an asset acquired on deferred payment terms for the effect of implicit borrowing costs.
Costs of testing whether an asset is functioning properly (for profit entities)
NZ IAS 16, paragraph 17(e) currently permits the costs of testing whether an asset is working properly to be capitalised into the cost of PPE, after deducting the net proceeds from selling any items produced while bringing the asset to the relevant location and condition.
There is currently diversity in practice as to the timing when deducting these sale proceeds ceases, with some deducting only sale proceeds from actual test items produced, and others deducting all sale proceeds from any items (be they test items or not) until the asset is available for use.
As a result, IASB ED 2017/4 Property, Plant and Equipment – Proceeds before Intended Use proposes to clarify that all proceeds from selling items prior to the PPE item being available for use are recognised as revenue, and not as a reduction in the cost of the PPE item.
For more information on the proposals, please refer to Accounting Alert article (August 2017)
Our next edition will cover more common errors when accounting for PPE.
For more on the above, please contact your local BDO representative.