FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with property, plant and equipment in Section 17 Property, Plant and Equipment.
The term ‘property, plant and equipment’ is defined as:
‘Tangible assets that:
(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and
(b) are expected to be used during more than one period.’
Property, plant and equipment (PPE) will therefore encompass items such as:
- Land and buildings (but not investment property);
- Plant and machinery;
- Fixtures and fittings;
- Motor vehicles; and
- Computer equipment.
Expenditure can only be classified as PPE when:
- It is probable (ie more likely than not) that future economic benefits associated with the item will flow to the entity; and
- The cost of the item can be measured reliably.
Therefore, in order to be able to recognise an asset, the item must not only have a reliable measure of cost, but it must also create economic benefits for the entity. There is, however, some overlap with the definition of an ‘asset’ in the Glossary to FRS 102 which is:
‘A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.’
You can see that the definition also refers to economic benefits flowing to the entity but, in addition, the definition also requires the entity to ‘control’ the asset. ‘Control’ in this context means ensuring that the benefits accrue to the entity and not to others. It can also mean the entity has the ability to decide what will happen to the asset and when (e.g. when the asset will ultimately be disposed of).
When an item meets the definition of an asset and it is capitalised on the balance sheet (statement of financial position), it is initially recognised at its cost price. Cost can (and often does) include more than just the purchase price; for example, cost can include:
- Irrecoverable taxes (such as VAT if the entity is not VAT-registered);
- Freight costs in getting the asset transported to its location;
- Installation and assembly costs; and
- Legal fees
Cost is stated net of any trade discounts and rebates.
After initial recognition at cost, the asset is then measured under either the cost model or the revaluation model. The majority of assets are usually measured under the cost model which is:
- Cost; less
- Depreciation; and less
- Any impairment losses.
Alternatively, the entity may choose to subsequently measure an asset under the revaluation model. However, where an entity does choose to subsequently measure an asset under the revaluation model, it must measure all assets in the same class under the revaluation model (FRS 102, paragraph 17.15). The term ‘class of assets’ is defined as:
‘A grouping of assets of a similar nature and use in an entity’s operations.’
All assets in the same class must be revalued where the revaluation model is applied to stop entities from deliberately revaluing certain assets which have increased in value and omitting those which may have decreased in value. Future articles will examine how the revaluation model under Section 17 works in practice.
Most fixed assets will incur some subsequent expenditure and this is likely to be in the form of repairs and maintenance costs. For example, a machine which has a useful economic life of five years is unlikely to operate throughout its five-year lifecycle without some form of maintenance being incurred on it.
FRS 102, paragraph 17.15 requires an entity to recognise the costs of day-to-day servicing of an item of property, plant and equipment in profit or loss in the period in which the costs are incurred. Such costs are not eligible to be capitalised as part of the cost of the asset.
However, where the entity incurs subsequent expenditure on an asset which enhances the service potential of the asset, then the expenditure may qualify for recognition on the balance sheet as part of the cost of the asset. This would occur when:
- The expenditure meets the general recognition criteria for an asset (see above) – in particular, the expenditure will result in probable future economic benefits flowing to the entity; and
- Any part of the existing asset which has been replaced is derecognised, regardless of whether it has been depreciated separately.
Only subsequent expenditure which can provide an incremental benefit should be capitalised. In other words, the subsequent expenditure enhances the economic benefits expected to flow from the asset in excess of its previously assessed standard of performance.
For example, where a machine is capable of producing 200 units of output per hour and a major component is replaced which results in the machine producing 400 units of output per hour, this clearly enhances the asset beyond its previously assessed standard of performance. Provided the major component has a cost or value which can be reliably measured and economic benefits are expected to flow to the entity as a result of the expenditure, the major component can be capitalised as part of the cost of the asset. The replaced component is derecognised in the same way as a normal disposal of a fixed asset.
There may be occasions when an entity incurs both repairs and maintenance costs as well as significant modification costs to a specific item of property, plant and equipment. In such cases, it will be necessary to analyse the expenditure according to its nature. Repairs and maintenance costs will be expensed to profit and loss; although the significant modification costs should be capitalised as part of the cost of the asset where the recognition criteria is met (i.e. where it is probable that future economic benefits associated with the modification will flow to the entity).
The issue of subsequent expenditure can be subjective and careful thought needs to be given as to whether the expenditure is repairs and maintenance expenditure (i.e. is it merely maintaining the asset) or does it enhance the asset beyond its previously assessed standard of performance. Where it is the latter, the costs may be capitalised if they meet the recognition criteria and any replaced parts are derecognised.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.