Blind Freddy – Common errors when accounting for property, plant and equipment (IAS 16)
The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors  (Centro case) to describe glaringly obvious mistakes.
In 2018 we continue our successful ‘Blind Freddy’ series, this month highlighting some common ‘Blind Freddy’ errors when accounting for property, plant and equipment (PPE) in the entity’s financial statements. IAS 16 Property, Plant and Equipment is the accounting standard which sets out the key principles for recognising and measuring PPE. 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 IAS 16 are not particularly complex, there are nevertheless a number of areas where preparers make common ‘Blind Freddy’ 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 ten ‘Blind Freddy’ errors relating to the scope of IAS 16, as well as common errors regarding what can and cannot be included as part of the ‘cost’ of an item of PPE.
Blind Freddy error 1 – Accounting for items as PPE which are not within the scope of IAS 16
IAS 16 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 IAS 16:
||Accounted for under other standards
||IAS 40 Investment Property
|Biological assets related to agricultural activity (other than bearer plants)
||IAS 41 Agriculture
|Exploration and evaluation assets
||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 IAS 16, 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 rather than profit or loss, masking earnings volatility for certain property companies, and
- Biological assets such as sheep or cattle at cost when the relevant standard, IAS 41 requires measurement at ‘fair value less costs to sell’.
Blind Freddy error 1
Applying the wrong accounting standard to account for items of PPE that are scoped out of IAS 16.
Blind Freddy error 2 – Bearer plants accounted for as biological assets
IAS 41 applies to ‘biological assets’ which are living animals or plants. Certain items meet the definition of a ‘biological asset’ (e.g. dairy cattle, sheep, fruit trees, oil palms, rubber trees, etc.) but are considered ‘bearer plants’ and therefore accounted for as PPE under IAS 16.
|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.
IAS 16 - Definition of ‘bearer plant’
A common ‘Blind Freddy’ 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.
Blind Freddy 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 IAS 16.
Blind Freddy error 3 – All plants accounted for as bearer plants
IAS 16, paragraph 3(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 IAS 41:
- 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.
Blind Freddy error 3
Accounting for all plants as bearer plants as PPE under IAS 16, instead of as biological assets under IAS 41.
Blind Freddy error 4 – Bearer ‘animals’ treated as bearer plants
Following on from Blind Freddy error 2 above, bearer plants are accounted for under IAS 16. 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 IAS 16, 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.
Blind Freddy error 4
Accounting for animals with features similar to bearer plants as PPE.
Blind Freddy 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.
IAS 16, paragraph 8 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.
Blind Freddy error 5
Assuming all spare parts and stand-by and servicing equipment are inventories.
Blind Freddy 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)
IAS 16, paragraph 15 requires items of PPE to be initially measured at ‘cost’, which includes the purchase price and various other costs (refer extract of paragraph 16 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 (paragraph 20).
|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.
IAS 16, paragraph 16
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.
IAS 16, paragraph 20
A common ‘Blind Freddy’ 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.
Blind Freddy 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.
Blind Freddy error 7 – Omitting estimated ‘make good’ costs from the cost of PPE when the entity has a present obligation as a result of a past obligating event
IAS 16, paragraph 16(c) requires the cost of an item of PPE to include the initial estimate of certain ‘restoration costs’ if an entity incurs an obligation for these, 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.
‘Restoration costs’ include the costs of dismantling and removing the item, and restoring the site on which it is located.
Although the point in time at which restoration obligations are recognised under IAS 37 Provisions, Contingent Liabilities and Contingent Assets can be judgemental, once it has been established that an entity has a ‘present obligation as a result of a past event’ under IAS 37, the debit side of this provision entry is made to the relevant PPE item. The cost of the item of PPE is increased by the provision amount, and is depreciated over the useful life of the asset.
Entity XYZ enters into a 10-year lease for office premises (no fit out) and is accounted for as an operating lease under IAS 17 Leases.
Entity XYZ conducts a fit out and installs various partitions, carpets, a kitchen and a bathroom which are all capitalised as leasehold improvements.
At the end of the lease, Entity XYZ is required to restore the premises to its original condition, i.e. remove all improvements.
Once the fit out has been completed, Entity XYZ has a present obligation to make good the premises at the end of the lease. This obligation arises as a result of a past event under IAS 37 (i.e. by installing the leasehold improvements).
Entity XYZ therefore estimates the restoration costs at the end of Year 10, discounts these costs to present value at the time of fit-out, and adds this discounted amount onto the cost of leasehold improvements.
It is important to note, however, that if there is no lease, i.e. Entity XYZ undertakes improvements to its own premises, the ‘intention’ of Entity XYZ to dismantle the fit out at the end of its useful life does not create an obligation under IAS 37 because there is no lease. In such cases, dismantling costs would not be included in the cost of PPE.
Blind Freddy error 7
Omitting ‘make good’ costs from the cost of leasehold improvements when the entity has a present obligation as a result of a past event under IAS 37 to ‘make good’ lease premises.
Blind Freddy error 8 – Failing to capitalise borrowing costs on self-constructed qualifying assets
The current version of 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. 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!
Blind Freddy error 8
Expensing borrowing costs incurred when constructing a qualifying asset.
For more information, please refer to our Accounting News article on common errors in applying IAS 23.
Blind Freddy error 9 – Ceasing capitalisation of borrowing costs too late
At the opposite end of the spectrum to Blind Freddy error 8 above, some entities continue to capitalise borrowing costs on self-constructed qualifying assets beyond the time permitted by 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 ‘Blind Freddy’ 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.
Blind Freddy error 9
Continuing to capitalise borrowing costs after the qualifying asset is ready to be used or sold.
For more information, please refer to our Accounting News article on common errors in applying IAS 23.
Blind Freddy error 10 – Not reducing the cost of PPE for the effect of deferred payment terms
Another common ‘Blind Freddy’ 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.
IAS 16, paragraph 23 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 IAS 23).
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 IAS 23.
IAS 16, paragraph 23
Blind Freddy error 10
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
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, an Exposure Draft ED 280 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 News article (July 2017)
Please continue reading next month for more ‘Blind Freddy’ errors when accounting for PPE.