3.3.1.A Spare parts and minor items

Spare parts, stand-by equipment and servicing equipment are recognised in accordance with Section 17 when they meet the definition of PP&E. Otherwise, such items are classified as inventory. [FRS 102.17.5].

The wording above reflects an amendment made as part of the Triennial review 2017 and is now consistent with the wording used in paragraph 8 of IAS 16. Prior to the amendment Section 17 contained a requirement that spare parts and servicing equipment that can only be used in connection with an item of PP&E must be classified as PP&E. The Triennial review 2017 amendments to FRS 102 are effective for periods beginning on or after 1 January 2019, with early adoption permitted provided that all the Triennial review 2017 amendments are applied at the same time. [FRS 102.1.18]. The amendment should be applied retrospectively.

Some types of business may have a very large number of minor items of PP&E such as spare parts, tools, pallets and returnable containers, which nevertheless are used in more than one accounting period. There are practical problems in recording them on an asset-by-asset basis in an asset register; they are difficult to control and frequently lost. The main consequence is that it becomes very difficult to depreciate them. Generally, entities write off such immaterial assets as expenses in the period of addition. Section 17 does not prescribe what actually constitutes a single item of PP&E. Therefore, in our view, entities have to apply judgement in defining PP&E in their individual circumstances. It may be appropriate to aggregate some parts (such as tools, moulds and dies) and to apply the requirements of Section 17 to the aggregate amount (presumably without having to identify the individual assets).

Materiality judgements are considered when deciding how an item of PP&E should be accounted for. Major spare parts, for example, qualify as PP&E, while smaller spares would be carried as inventory and as a practical matter many companies have a minimum value for capitalising assets.

3.3.1.B Environmental and safety equipment

There may be expenditures forced upon an entity by legislation that requires it to buy ‘assets’ that do not meet the recognition criteria because the expenditure does not directly increase the expected future benefits expected to flow from the asset. Examples would be safety or environmental protection equipment. While Section 17 has no specific guidance, it would be reasonable to consider the related guidance in IFRS.

IAS 16 explains that these expenditures qualify for recognition as they allow future benefits in excess of those that would flow if the expenditure had not been made; for example, a plant might have to be closed down if these environmental testing expenditures were not made. [IAS 16.11].

An entity may voluntarily invest in environmental equipment even though it is not required by law to do so. The entity can capitalise those investments in environmental and safety equipment in the absence of a legal requirement as long as:

• the expenditure meets the definition of an asset; or
• there is a constructive obligation to invest in the equipment.

If the entity can demonstrate that the equipment is likely to increase the economic life of the related asset, the expenditure meets the definition of an asset. Otherwise, the expenditure can be capitalised when the entity can demonstrate all of the following:

• the entity can prove that a constructive obligation exists to invest in environmental and safety equipment (e.g. it is standard practice in the industry, environmental groups are likely to raise issues or employees demand certain equipment to be present);
• the expenditure is directly related to improvement of the asset's environmental and safety standards; and
• the expenditure is not related to repairs and maintenance or forms part of period costs or operational costs.

Consistent with IAS 16, whenever safety and environmental assets are capitalised, the resulting carrying amount of the asset, and any related asset, are required to be reviewed for impairment in accordance with Section 27 – Impairment of Assets (see 3.5.7 below).

3.3.1.C Property economic benefits and property developments

Section 17 requires that PP&E is recognised only when it is probable that future economic benefits associated with the item will flow to the entity.

For example, in relation to property development, many jurisdictions require permissions prior to development whilst developers, including entities developing property for their own use, typically incur significant costs prior to such permissions being granted.

In assessing whether such pre-permission expenditures can be capitalised – assuming they otherwise meet the criteria – a judgement must be made at the date the expenditure is incurred of whether it is sufficiently probable that the relevant permission will be granted. Such expenditure does not become part of the cost of the land; to the extent that it can be recognised it will be as part of the cost of a separate building. Furthermore, if the granting of necessary permits is no longer expected during the application and approval process, capitalisation of pre-permission expenditures should cease and any related amounts that were previously capitalised should be written off in accordance with Section 27.

3.3.1.D Classification as PP&E or intangible assets

The restrictions in Section 18 – Intangible Assets other than Goodwill – in respect of capitalising certain internally-generated intangible assets focus attention on the treatment of many internal costs. In practice, items such as computer software purchased by entities are frequently capitalised as part of a tangible asset, for example as part of an accounting or communications infrastructure. Equally, internally written software may be capitalised as part of a tangible production facility, and so on. Judgement must be exercised in deciding whether such items are to be accounted for under Section 17 or Section 18, and this distinction becomes increasingly important if the two sections prescribe differing treatments in any particular case.

Both Section 17 and Section 18 do not refer to this type of asset, however, it is reasonable to consider guidance provided in IFRS. IAS 38 – Intangible Assets – states that an entity needs to exercise judgement in determining whether an asset that incorporates both intangible and tangible elements should be treated as PP&E or as an intangible asset, for example:

• computer software that is embedded in computer-controlled equipment that cannot operate without that specific software is an integral part of the related hardware and is treated as PP&E;
• application software that is being used on a computer is generally easily replaced and is not an integral part of the related hardware, whereas the operating system normally is integral to the computer and is included in PP&E; and
• a database that is stored on a compact disc is considered to be an intangible asset because the value of the physical medium is wholly insignificant compared to that of the data collection. [IAS 38.4].

It is worthwhile noting that as the ‘parts approach’ in Section 17 (see 3.3.2 below) requires an entity to account for significant parts of an asset separately, this raises ‘boundary’ problems between Section 17 and Section 18 when software and similar expenditure are involved. We believe that where Section 17 requires an entity to identify significant parts of an asset and account for them separately, the entity needs to evaluate whether any software-type intangible part is actually integral to the larger asset or whether it is really a separate asset in its own right. The intangible part is more likely to be an asset in its own right if it was developed separately or if it can be used independently of the item of PP&E.

3.3.1.E Classification of items as inventory or PP&E when minimum levels are maintained

Entities may acquire items of inventory on a continuing basis, either for sale in the ordinary course of business or to be consumed in a production process or when rendering services. This means there will always be a core stock of that item (i.e. a minimum level of inventory is maintained). This does not in itself turn inventory into an item of PP&E, since each individual item will be consumed in a single operating cycle. However, there may be cases where it is difficult to judge whether an item is part of inventory or is an item of PP&E. This may have implications on measurement because, for example, PP&E has a revaluation option (see 3.6 below) that is not available for inventory.

In our view, an item of inventory is accounted for as an item of PP&E if it:

• is not held for sale or consumed in a production process or during the process of rendering services;
• is necessary to operate or benefit from an asset during more than one operating cycle; and
• cannot be recouped through sale (or is significantly impaired after it has been used to operate the asset or benefit from that asset).

This applies even if the part of inventory that is an item of PP&E cannot be physically separated from the rest of inventories.

Consider the following examples:

• An entity acquires the right to use an underground cave for gas storage purposes for a period of 50 years. The cave is filled with gas, but a substantial part of that gas will only be used to keep the cave under pressure in order to be able to get gas out of the cave. It is not possible to distinguish the gas that will be used to keep the cave under pressure and the rest of the gas.
• An entity operates an oil refining plant. In order for the refining process to take place, the plant must contain a certain minimum quantity of oil. This can only be taken out once the plant is abandoned and would then be polluted to such an extent that the oil's value is significantly reduced.
• An entity sells gas and has at any one time a certain quantity of gas in its gas distribution network.

In the first example, therefore, the total volume of gas must be virtually split into (i) gas held for sale and (ii) gas held to keep the cave under pressure. The former must be accounted for under Section 13 – Inventories. The latter must be accounted for as PP&E and depreciated over the period the cave is expected to be used.

In the second example the part of the crude that is necessary to operate (in technical terms) the plant and cannot be recouped (or can be recouped but would then be significantly impaired), even when the plant is abandoned, should be considered as an item of PP&E and amortised over the life of the plant.

In the third example the gas in the pipeline is not necessary to operate the pipeline. It is held for sale or to be consumed in the production process or process of rendering services. Therefore this gas is accounted for as inventory.

3.3.1.F Production stripping costs of surface mines

Under FRS 102, there is no specific guidance on production stripping costs of surface mines. However, the approach in Section 17 in relation to accounting for parts (see 3.3.2 below) seems to be consistent with the specific guidance provided in IFRS.

IFRIC 20 – Stripping Costs in the Production Phase of a Surface Mine – states that costs associated with a ‘stripping activity asset’ (i.e. the costs associated with gaining access to a specific section of the ore body) are accounted for as an additional component of an existing asset. Other routine stripping costs are accounted for as current costs of production (i.e. inventory).

The Interpretations Committee's intention was to maintain the principle of IAS 16 by requiring identification of the component of the ore body for which access had been improved, as part of the criteria for recognising stripping costs as an asset. An entity will have to allocate the stripping costs between the amount capitalised (as it reflects the future access benefit) and the amount that relates to the current-period production of inventory. This allocation should be based on a relevant production measure.

This component approach follows the principle of separating out parts of an asset that have costs that are significant in relation to the entire asset and when the useful lives of those parts are different. [IAS 16.45].

3.3.2.A Land and buildings

Section 17 requires that the land and the building elements of property are treated as separate assets and accounted for separately, even when they are acquired together. [FRS 102.17.8].

3.3.3.A Cost of major inspections

A condition of continuing to operate an item of PP&E (e.g. a bus) may include a requirement to perform regular major inspections for faults regardless of whether parts of the item are replaced. Section 17 requires the cost of each major inspection performed to be recognised in the carrying amount of the item of PP&E as a replacement (and considered a separate part) if the recognition criteria are satisfied (see 3.3 above). Any remaining carrying amount of the cost of the previous major inspection (as distinct from physical parts) is derecognised. This is done regardless of whether the cost of the previous major inspection was identified in the transaction in which the item was acquired or constructed. If necessary, the estimated cost of a future similar inspection may be used as an indication of what the cost of the existing inspection component was when the item was acquired or constructed. [FRS 102.17.7]. Accordingly, if the element relating to the inspection had previously been identified, it would have been depreciated between that time and the current overhaul. However, if it had not previously been identified, the recognition and derecognition rules still apply, but Section 17 appears to allow the entity to reconstruct the carrying amount of the previous inspection (i.e. to estimate the net depreciated carrying value of the previous inspection that will be derecognised using the estimated cost of a future similar inspection as an indication of the cost of the existing inspection component that must be derecognised).

3.4.1.A ‘Directly attributable’ costs

This is the key issue in the measurement of cost. Section 17 gives examples of types of expenditure that are, and are not, considered to be directly attributable. The following are examples of those types of expenditure that are considered to be directly attributable and hence may be included in cost at initial recognition: [FRS 102.17.10(b)]

• costs of site preparation;
• initial delivery and handling costs;
• installation and assembly costs; and
• cost of testing of functionality.

While FRS 102 has no further guidance relating to costs of testing whether the asset is functioning properly, it is reasonable and common practice to recognise costs after deducting the net proceeds from selling any items produced while bringing the asset to its location and condition (such as samples produced when testing equipment). Income received during the period of construction of PP&E is considered further at 3.4.2 below.

In our view, amounts charged under operating leases during the construction period of an asset may also be a directly attributable cost that may be included as part of the cost of the PP&E if those lease costs are ‘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’. [FRS 102.17.10(b)]. This may be the case, for example, where a building is constructed on land that is leased under an operating lease. This approach must be applied consistently.

Other types of costs expected to be considered to be directly attributable costs are the following:

• costs of employee benefits (as defined in Section 28 – Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment. This means that the labour costs of an entity's own employees (e.g. site workers, in-house architects and surveyors) arising directly from the construction, or acquisition, of the specific item of PP&E may be recognised; and
• professional fees.

3.4.1.B Borrowing costs

Entities are not required to capitalise borrowing costs. However, in line with item (d) at 3.4.1 above and Section 25, such costs may be capitalised in respect of certain qualifying assets to the extent that entities choose to capitalise borrowing costs in respect of such assets. The treatment of borrowing costs is discussed separately in Chapter 22.

3.4.1.C Costs that are not PP&E costs

The following costs are not costs of PP&E and must be recognised as an expense when they are incurred: [FRS 102.17.11]

• costs related to opening a new facility;
• costs of introducing a new product or service (including costs of advertising and promotional activities);
• costs of conducting business in a new territory or with a new class of customer (including costs of staff training); and
• administration and other general overhead costs.

These costs should be accounted for (in general, expensed as incurred) in the same way as similar costs incurred as part of the entity's on-going activities.

Administration and other general overhead costs are not costs of an item of PP&E. This means that employee costs not related to a specific asset, such as site selection activities and general management time, do not qualify for capitalisation.

3.4.1.D Cessation of capitalisation

Only those costs directly attributable to bringing the asset to the location and condition for it to be capable of being operated in a manner intended by management can be capitalised. [FRS 102.17.10(b)]. Once that has occurred capitalisation should cease. This will usually be the date of practical completion of the physical asset. An entity is not precluded from continuing to capitalise costs during an initial commissioning period that is necessary for installation or assembly or testing equipment.

3.4.1.E Self-built assets

Section 17 is silent on construction costs of an item of self-built PP&E. If an asset is self-built by the entity, the same general principles apply as for an acquired asset i.e. only those costs directly attributable to bringing the asset to the location and condition for it to be capable of being operated in a manner intended by management can be capitalised. This includes assembly costs. [FRS 102.17.10(b)]. Consistent with IAS 16 and common practice, abnormal amounts of wasted resources, whether labour, materials or other resources, should not be included in the cost of self-built assets. [IAS 16.22]. Section 25, discussed in Chapter 22, contains criteria relating to the recognition of any interest as a component of a self-built item of PP&E

If the same type of asset is made for resale by the business, it should be recognised at cost of production, but including attributable overheads in accordance with Section 13 (see Chapter 11 at 3.3.3). [FRS 102.13.8-9].

3.4.1.F Deferred payment

The cost of an item of PP&E is its cash price equivalent at the recognition date. This means that if payment is made in some other manner, the cost to be capitalised is the normal cash price. If the payment terms are extended beyond ‘normal’ credit terms, the cost to be recognised must be the present value of all future payments. [FRS 102.17.13]. Accordingly, any difference between the present value and the total payments must be treated as an interest expense over the period of credit. Assets held under finance leases are discussed in Chapter 18.

3.4.1.G Land and buildings to be redeveloped

It is common for property developers to acquire land with an existing building where the planned redevelopment necessitates the demolition of that building and its replacement with a new building that is to be held to earn rentals or will be owner occupied. Whilst Section 17 requires that the building and land be classified as two separate items, [FRS 102.17.8], in our view it is appropriate, if the existing building is unusable or likely to be demolished by any party acquiring it, that the entire, or a large part of, the purchase price be allocated to land. Similarly, subsequent demolition costs should be treated as being attributable to the cost of the land.

Owner-occupiers may also replace existing buildings with new facilities for their own use or to rent to others. Here the consequences are different and the carrying amount of the existing building cannot be rolled into the costs of the new development. The existing building must be depreciated over its remaining useful life to reduce the carrying amount of the asset to its residual value (presumably nil) at the point at which it is demolished. Consideration will have to be given as to whether the asset is impaired in accordance with Section 27. Many properties do not directly generate independent cash inflows (i.e. they are part of a cash-generating unit) and reducing the useful life will not necessarily lead to an impairment of the cash-generating unit, although by the time the asset has been designated for demolition it may no longer be part of a cash-generating unit (see Chapter 24).

Developers or owner-occupiers replacing an existing building with a building to be sold in the ordinary course of their business will deal with the land and buildings under Section 13 (see Chapter 11 at 3.2.1.B).

3.4.1.H Transfers of assets from customers

Section 17 has no specific guidance on transfers of assets from customers other than for circumstances when the transfer involves an exchange of assets – see 3.4.4 below. Transfers that are government grants are within the scope of Section 24 – Government Grants (discussed in Chapter 21). Assets used in a service concession or resources from non-exchange transactions are within the scope of Section 34 (see Chapter 31). Accordingly, an entity applying FRS 102 may use the principles set out in these sections of FRS 102 and at 3.4.4 below – i.e. recognition of the asset transferred at fair value. [FRS 102.17.14, 24.5, 34.14].

3.4.1.I Variable consideration

The final purchase price of an item of PP&E is not always known when the terms include a variable or contingent amount that is linked to future events that cannot be determined at the date of acquisition. The total consideration could vary based on the performance of an asset – for example, the revenue or EBITDA generated, for a specified future period, by the asset or a business in which the asset is used. Generally, we would believe that a financial liability relating to variable consideration arises on the purchase of an item of PP&E and any measurement changes to that liability would be recorded in the statement of profit or loss as required by Section 12 – Other Financial Instruments Issues. However, in some instances contracts are more complex and it can be argued that the subsequent changes to the initial estimate of the purchase price should be are capitalised as part of the asset, similar to any changes in a decommissioning liability (see 3.4.3 below). Further, many consider that these are executory payments that are not recognised until incurred.

In the absence of specific guidance, an entity should develop an accounting policy for variable consideration relating to the purchase of PP&E in accordance with the hierarchy in Section 10 – Accounting Policies, Estimates and Errors. [FRS 102.10.4-6]. In practice, there are different approaches for treating the estimated future variable payments. Some entities do not capitalise these amounts upon initial recognition of the asset and then either expense or capitalise any payments as they are incurred. Other entities include an estimate of future amounts payable on initial recognition with a corresponding liability being recorded. Under this approach subsequent changes in the liability are either capitalised or expensed. An entity should exercise judgement in developing and consistently applying an accounting policy that results in information that is relevant and reliable in its particular circumstances. [FRS 102.10.4]. For more discussion see Chapter 16 at 4.3.

3.4.2.A Income received during the construction of property

One issue that commonly arises is whether rental and similar income generated by existing tenants in a property development may be capitalised and offset against the cost of developing that property.

The relevant question is whether the leasing arrangements with the existing tenants are a necessary activity to bring the development property to the location and condition necessary for it to be capable of operating in the manner intended by management. Whilst the existence of the tenant may be a fact, it is not a necessary condition for the building to be developed to the condition intended by management; the building could have been developed in the absence of any existing tenants.

Therefore, rental and similar income from existing tenants are incidental to the development and should not be capitalised. Rather rental and similar income should be recognised in profit or loss in accordance with the requirements of Section 20 together with related expenses.

3.4.2.B Liquidated damages during construction

Income may arise in other ways, for example, liquidated damages received as a result of delays by a contractor constructing an asset. Normally such damages received should be set off against the asset cost – the purchase price of the asset is reduced to compensate for delays in delivery.

3.4.4.A Commercial substance

Section 17 does not provide further guidance on ‘commercial substance’ and therefore the application of this term will involve judgement and careful consideration of facts and circumstances. In addition, an entity may also consider the guidance provided under IFRS – the commercial substance test was put in place as an anti-abuse provision to prevent gains in income being recognised when the transaction had no discernible effect on the entity's economics. [IAS 16.BC21]. The commercial substance of an exchange is to be determined by forecasting and comparing the future cash flows budgeted to be generated by the incoming and outgoing assets. For there to be commercial substance, there must be a significant difference between the two forecasts. IAS 16 sets out this requirement as follows:

‘An entity determines whether an exchange transaction has commercial substance by considering the extent to which its future cash flows are expected to change as a result of the transaction. An exchange transaction has commercial substance if:

1. the configuration (risk, timing and amount) of the cash flows of the asset received differs from the configuration of the cash flows of the asset transferred; or
2. the entity-specific value of the portion of the entity's operations affected by the transaction changes as a result of the exchange; and
3. the difference in (a) or (b) is significant relative to the fair value of the assets exchanged.’ [IAS 16.25].

As set out in the definitions of IAS 16, entity-specific value is the net present value of the future predicted cash flows from continuing use and disposal of the asset. Post-tax cash flows should be used for this calculation. IAS 16 contains no guidance on the discount rate to be used for this exercise, nor on any of the other parameters involved, but it does suggest that the result of these analyses might be clear without having to perform detailed calculations. [IAS 16.25]. Care will have to be taken to ensure that the transaction has commercial substance as defined in IAS 16 if an entity receives a similar item of PP&E in exchange for a similar asset of its own. Commercial substance may be difficult to demonstrate if the entity is exchanging an asset for a similar one in a similar location. However, in the latter case, the risk, timing and amount of cash flows could differ if one asset were available for sale and the entity intended to sell it whereas the previous asset could not be realised by sale or only sold over a much longer timescale. It is feasible that such a transaction could meet the conditions (a) and (c) above. However, it would be unusual if the entity-specific values of similar assets differed enough in any arm's length exchange transaction to meet condition (c).

Other types of exchange are more likely to pass the ‘commercial substance’ test, for example exchanging an interest in an investment property for one that the entity uses for its own purposes. The entity has exchanged a rental stream and instead has an asset that contributes to the cash flows of the cash-generating unit of which it is a part. In this case it is probable that the risk, timing and amount of the cash flows of the asset received would differ from the configuration of the cash flows of the asset transferred.

3.5.4.A Repairs and maintenance

The initial assessment of the useful life of the asset will take into account the expected routine spending on repairs and expenditure necessary for it to achieve that life. Although Section 17 implies that this refers to an item of plant and machinery, care and maintenance programmes are relevant to assessing the useful lives of many other types of asset. For example, an entity may assess the useful life of a railway engine at thirty-five years on the assumption that it has a major overhaul every seven years. Without this expenditure, the life of the engine would be much less certain and could be much shorter. Maintenance necessary to support the fabric of a building and its service potential is also taken into account in assessing its useful life. Eventually, it will always become uneconomic for the entity to continue to maintain the asset so, while the expenditure may lengthen the useful life, it is unlikely to make it indefinite.

Note that this applies whether the expenditure is capitalised because it meets the definition of a ‘major inspection’ (see 3.3.3.A above) or if it is repairs and maintenance that is expensed as incurred.

3.5.4.B Land

As discussed in 3.3.2.A above, land and buildings are separable assets and must be accounted for separately, even when they are acquired together. [FRS 102.17.8]. Land, which generally has an unlimited life, is not usually depreciated. [FRS 102.17.16]. A building is a depreciable asset and its useful life is not affected by an increase in the value of the land on which it stands.

Although land generally has an unlimited useful life, there may be circumstances in which depreciation could be applied to land. In those instances in which land has a finite life it will be either used for extractive purposes (a quarry or mine) or for some purpose such as landfill; it will be depreciated in an appropriate manner but it is highly unlikely that there will be any issue regarding separating the interest in land from any building element. However, the cost of such land may include an element for site dismantlement or restoration (see 3.4.3 above), in which case this element will have to be separated from the land element and depreciated over an appropriate period (i.e. the period of benefits obtained by incurring these costs) which will often be the estimated useful life of the site for its purpose and function. An entity engaged in landfill on a new site may make a provision for restoring it as soon as it starts preparation by removing the overburden. It will separate the land from the ‘restoration asset’ and depreciate the restoration asset over the landfill site's estimated useful life. If the land has an infinite useful life, an appropriate depreciation basis will have to be chosen that reflects the period of benefits obtained from the restoration asset.

While FRS 102 provides no specific guidance related to revision of estimated costs, an entity may consider the approach applied by IFRIC 1 (see 3.4.3 above and Chapter 19 at 4.1). Accordingly, if the estimated costs are revised, in accordance with IFRIC 1, the adjusted depreciable amount of the asset is depreciated over its useful life. Therefore, once the related asset has reached the end of its useful life, all subsequent changes in the liability will be recognised in profit or loss as they occur, irrespective of whether the entity applies the cost or revaluation model. [IFRIC 1.7].

3.5.4.C Technological change

A current or expected future reduction in the market demand for the product or service output of an asset may be evidence of technical or commercial obsolescence. Expected future reductions in the selling price of an item that was produced using an asset could also 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. If an entity anticipates technical or commercial obsolescence, it should reassess the residual value of an asset, its useful life or the pattern of consumption of future economic benefits. [FRS 102.17.19]. In such cases, it might be more appropriate to use a diminishing balance method of depreciation to reflect the pattern of consumption (see 3.5.6.B below).

The effects of technological change are often underestimated. It affects many assets, not only high technology plant and equipment such as computer systems. For example, many offices that have been purpose-built can become obsolete long before their fabric has physically deteriorated, for reasons such as the difficulty of introducing computer network infrastructures or air conditioning, poor environmental performance or an inability to meet new legislative requirements such as access for people with disabilities. Therefore, the estimation of an asset's useful life is a matter of judgement and the possibility of technological change must be taken into account.

3.5.6.A Straight-line method

The straight-line method of depreciation is well known and understood. Its simplicity makes it the most commonly used method in practice. The method is time-based and involves the use of a fixed percentage of the original cost of the asset in spreading the depreciable amount evenly over the useful life of the asset resulting in a constant depreciation charge over such period. It is considered the most appropriate method to use when the pattern of consumption of future economic benefits of an asset is expected to be constant year-on-year or when such pattern cannot be readily determined.

3.5.6.B Diminishing balance method

The diminishing balance method involves determining a percentage depreciation that will write off the asset's depreciable amount over its useful life. This involves calculating a rate that will reduce the asset's carrying amount to its residual value at the end of the useful life.

The sum of digits method is another form of the diminishing balance method, but one that is based on the estimated life of the asset and which can easily be applied if the asset has a residual value. If an asset has an estimated useful life of four years then the digits 1, 2, 3, and 4 are added together, giving a total of 10. Depreciation of four-tenths, three-tenths and so on, of the cost of the asset, less any residual value, will be charged in the respective years. The method is sometimes called the ‘rule of 78’, 78 being the sum of the digits 1 to 12.

3.5.6.C Units of production method

Under this method, the asset is written off in line with its estimated total output. By relating depreciation to the proportion of productive capacity utilised to date, it reflects the fact that the useful economic life of certain assets, principally machinery, is more closely linked to its usage and output than to time. This method is normally used in extractive industries, for example, to amortise the costs of development of productive oil and gas facilities.

The essence of choosing a fair depreciation method is to reflect the consumption of economic benefits provided by the asset concerned. In most cases the straight-line basis will give perfectly acceptable results, and the vast majority of entities use this method. Where there are instances, such as the extraction of a known proportion of a mineral resource, or the use of a certain amount of the total available number of working hours of a machine, it may be that units of production method will give fairer results.

3.5.7.A Compensation for impairment

The question has arisen about the treatment of any compensation an entity may be due to receive as a result of an asset being impaired. For example an asset that is insured might be destroyed in a fire, so repayment from an insurance company might be expected. These two events – the impairment and any compensation – are separate economic events and should be accounted for separately as follows:

• impairments of PP&E are recognised in accordance with Section 27 (see Chapter 24);
• derecognition of items retired or disposed of should be recognised in accordance with Section 17 (derecognition is discussed at 3.7 below); and
• compensation from third parties for PP&E that is impaired, lost or given up is included in profit and loss only when the compensation is virtually certain. [FRS 102.17.25].

3.5.7.B PP&E held for sale

An entity's plan to dispose of an asset before the previously expected date is an indicator of impairment that triggers the calculation of the asset's recoverable amount for the purpose of determining whether the asset is impaired. [FRS 102.17.26, 27.9(f)]. If the asset is impaired, then the carrying amount of the asset should be written down to its recoverable amount.

Although the entity plans to dispose of the asset, depreciation should continue until the asset is disposed. In addition, the plan to dispose an asset might indicate that the residual value or the remaining life of the asset needs adjustment even if there is no impairment.

3.6.2.A Income approach to fair value

Section 17 does not define what it means by an income approach. However, a definition is provided in IFRS 13 – Fair Value Measurement – which states that the income approach converts future amounts (e.g. cash flows or income and expenses) to a single discounted amount. The fair value reflects current market expectations about those future amounts. In the case of PP&E, this will usually mean using a discounted cash flow technique. [IFRS 13.B10, B11].

Further discussion of this valuation technique can be found in Chapter 14 of EY International GAAP 2019.

3.6.2.B Depreciated replacement cost

Depreciated replacement cost is defined as the most economic cost required for the entity to replace the service potential of an asset (including the amount that the entity will receive from its disposal at the end of its useful life) at the reporting date. [FRS 102 Appendix I]. The objective of DRC is to make a realistic estimate of the current cost of constructing an asset that has the same service potential as the existing asset.

As a DRC valuation is based on replacement cost, it is likely to give a higher valuation than one using market-based evidence that reflects the actual current condition of the asset. For this reason, it is necessary to ensure that the asset really is so specialised that such evidence cannot be obtained. It is also necessary to be satisfied that the potential profitability of the business is adequate to support the value derived on a DRC basis.

DRC approaches are often applied to the valuation of plant and machinery, as distinct from property assets, where there is rarely a market from which to derive a fair value.

3.6.3.A Depreciation of revalued assets

The fundamental objective of depreciation is to reflect in operating profit the cost of use of an item of PP&E (i.e. the amount of economic benefits consumed) in the period. This requires a charge to operating profit even if the asset has changed in value or has been revalued.

Section 17 is not specific as to the base amount of an item of PP&E to be used when computing the depreciation charge for the period. It might be best to use the average carrying value during the year, or else, the opening or closing balance may be used provided that it is used consistently in each period. In practice, the depreciation charge is generally based on the opening value and the written down asset is revalued as at the end of accounting period. The depreciation charge should be recognised as an expense, unless it qualifies to be capitalised as part of another asset (see discussion at 3.5.1 above).

While not explicitly addressed in Section 17, the revaluation surplus included in OCI may be transferred directly to retained earnings as the surplus is realised. [1 Sch 35(3)]. Accordingly, the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on its original cost may be transferred from the revaluation reserve to retained earnings as the asset is used by the entity. Any depreciation of the revalued part of an asset's carrying value is considered realised by being charged to profit or loss. Thus a transfer may be made of an equivalent amount from the revaluation surplus to retained earnings. However any transfer is made directly from revaluation surplus to retained earnings and not through profit or loss. This is illustrated in Example 15.4 below. Any remaining balance may be transferred from revaluation reserve to retained earnings when the asset is derecognised (see 3.7 below). Revaluation gains or losses arising from the disposal of PP&E are not recycled to profit or loss.

The effect on taxation, both current and deferred, of a policy of revaluing assets is recognised and disclosed in accordance with Section 29 – Income Tax. This is dealt with in Chapter 26.

FRS 102 does not provide specific guidance on accounting for accumulated depreciation when an item of PP&E is revalued. There are two usual methods of adjusting the carrying amount when an item of PP&E is revalued. At the date of revaluation, the asset is treated in one of the following ways:

• The accumulated depreciation is eliminated against gross carrying amount of the asset and the carrying amount is then restated to the revalued amount of the asset.
• The gross carrying amount is adjusted in a manner that is consistent with the revaluation of the carrying amount of the asset. For example, the gross carrying amount may be restated by reference to observable market data or it may be restated proportionately to the change in the carrying amount of the asset. The accumulated depreciation at the date of the revaluation is adjusted to equal the difference between the gross carrying amount and the carrying amount of the asset after taking into account accumulated impairment losses.

The first method available eliminates the amount of accumulated depreciation to the extent of the difference between the revalued amount and the carrying amount of the asset immediately before revaluation. This is illustrated in Example 15.5.

Under the observable market data approach, the gross carrying amount will be restated and its difference compared to the revalued amount of the asset will be absorbed by the accumulated depreciation. Using the example above, assume the gross carrying amount is restated to £75,000 by reference to the observable market data and the accumulated depreciation will be adjusted to £25,000 (i.e. the gross carrying amount of £75,000 less the carrying amount adjusted to its revalued amount of £50,000).

Alternatively, the gross carrying amount is restated proportionately to the change in carrying amount (i.e. a 25% uplift) resulting in the same revaluation movement as the methods above but the cost and accumulated depreciation carried forward reflect a gross cost of the asset of £87,500 and accumulated depreciation of £37,500. This method may be used if an asset is revalued using an index to determine its depreciated replacement cost (DRC) (see 3.6.2.B above).

3.7.2.A Joint control

In some cases there may be joint control over the asset (e.g. sale of an asset to a joint venture), in which case the arrangement will be within scope of Section 15 – Investments in Joint Ventures – which will determine how to account for the disposal and the subsequent accounting. Joint control is discussed in Chapter 13.

The retained interest will be analysed as a jointly controlled operation (JCO), a jointly controlled assets (JCA) or a jointly controlled entity (JCE). Undivided interests cannot be accounted for as joint ventures in the absence of joint control.

3.7.2.B Vendor retains control

If the asset is not jointly controlled in the subsequent arrangement, the vendor might retain control over the asset. The vendor will recognise revenue or it will be a financing arrangement. If it is the former, then the issue is the period and pattern over which revenue is recognised.

If the vendor retains control then it will not meet the criteria in Section 23 for treating the transaction as a sale, i.e. recognising revenue on entering into the arrangement. As discussed in Chapter 20, the entity must retain neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold in order to recognise revenue from the sale of goods. [FRS 102.23.10].

The arrangement could be akin to a lease, especially if the disposal is for a period of time. However, arrangements are only within the scope of Section 20 if they relate to a specified asset. Generally, a portion of a larger asset that is not physically distinct is not considered to be a specified asset. See Chapter 18.

If it is not a lease and the vendor continues to control the asset, the arrangement might be best characterised as akin to a performance obligation for services to be spread over the term of the arrangement. That is, the initial receipt would be a liability and recognised in profit and loss over time.

Alternatively, it could be a financing-type arrangement, in which case the proceeds would be classified as a financial liability. In effect, the vendor is trading a share of any revenue to which it is entitled in exchange for funding by the purchaser of one or more activities relating to the asset. The purchaser receives a return that is comparable to a lender's rate of return out of the proceeds of production. This could be by receiving a disproportionate share of output until it has recovered its costs (the financing it has provided) as well as the agreed rate of return for the funding. These arrangements are found in the extractive sector, e.g. carried interests and farm-outs (Chapter 31). In the development stage of a project, the asset in question will be classified as PP&E or as an intangible asset under Section 18. Under a carried interest arrangement the carried party transfers a portion of the risks and rewards of a property, in exchange for a funding commitment from the carrying party.

3.7.2.C Partial sale of a single-asset entity

Certain assets, particularly properties, may be bought and sold by transferring ownership of a separate legal entity formed to hold the asset (a ‘single-asset’ entity) rather than the asset itself. The asset could be realised through either an outright sale or partial disposal. If the asset is sold in its entirety the gain or loss on disposal is the difference between the net disposal proceeds and the carrying amount of the asset (which, in this example, is assumed to be equal to the carrying amount of the investment in a single-asset entity). [FRS 102.17.30]. This scenario may be straight-forward but in instances where there is a partial disposal of an investment in a single-asset entity (including a partial disposal of an asset) that results in a loss of control, the type of investment that is retained should be considered in determining the gain or loss on disposal.

If the retained interest is not a joint venture within the scope of Section 15, the structure should be assessed to determine whether the retained interest represents an undivided interest in the asset or an investment in an entity. This assessment is important if the structure would result in a different amount of gain or loss on disposal. Therefore, if the retained interest represents an undivided interest in the asset, the accounting result is the same as that for an investment in a jointly controlled asset i.e. a gain or loss is recognised only to the extent of the portion sold, because the sale of a portion of the shares in the entity that holds the asset is regarded as a partial sale of the asset. However, if the retained interest represents an investment in an entity, a gain or loss is recognised as if 100% of the investment in the single-asset entity had been sold because control has been lost. This is consistent with principles when an entity lost control of a subsidiary or lost joint control of a jointly controlled entity – see Chapter 8 and Chapter 13, respectively. A financial asset or an interest in an associate is recognised, as appropriate, for the ownership interest retained. [FRS 102.9.19, 15.18].