Thursday, October 22, 2009

How IAS 16 regulates the Depreciation of PPE ?

IAS 16 Property, Plant and Equipment Par. 43 states that each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately, and such depreciation charge shall be charged to the income statement unless it is included in the cost of producing another asset.

Depreciation shall be applied to the depreciable amount of an asset on a systematic basis over its expected useful life.

Expected useful life is the period used, not the asset’s economic life, which could be appreciably longer (IAS 16 Par. 57 states that the useful life of an asset is defined in terms of the asset’s expected utility to the entity. The asset management policy of the entity may involve the disposal of assets after a specified time or after consumption of a specified proportion of the future economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter that its economic life. The estimation of the useful life of the asset is a matter of judgement based on the experience of the entity with similar assets).

The depreciable amount takes account of the expected residual value of the assets. Both the useful life and the residual value shall be reviewed annually and the estimates revised as necessary in accordance with IAS 8.

Depreciation still needs to be charged even if the fair value of an asset exceeds its residual value. The rationale for this is the definition of residual value, detailed above.

Residual value is the estimated amount, less estimated disposal costs, that could be currently realized from the asset’s disposal if the asset were already of an age and condition expected at the end of its useful life. This definition precludes the effect of inflation and, in all likelihood, will be less than fair value.

Depreciation commences when an assets is in the location and condition that enables it to be used in the manner intended by management. Depreciation shall cease at the earlier of its derecognition (sale or scrapping) or its reclassification as “held for sale”. Temporary idle activity does not preclude depreciating the asset, as future economic benefits are consumed not only through usage but also through wear and tear and obsolescence.

Useful life, therefore needs to be carefully determined based on use, maintenance programs, expected capacity, expected output, expected wear and tear, technical or commercial innovations, and legal limits.

(Source : IFRS Practical Implementation Guide and Workbook 2nd Edition)

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