ACCA DipIFR question papers and answers on IAS16 from June 2014
About
All questions on IAS 16 Property, plant and equipment which have appeared in ACCA DipIFR from June 2014 have been indexed here. The answers are based on the standards prevalent at the exam point in time.
For the benefit of the readers, we have put the following sequentially to help them understand better
- Question - Relevant portion of the exam pertaining to the standard has been recreated
- Answer - Answers as shared by the ACCA Examination team which was required for the question
- Examiners Feedback - Feedback on answers given by the students for that exam, this is a critical part of learning as students can learn from mistakes which other students did
ACCA Past question papers Dec 2015 (7 marks)
Question
Delta is an entity which is engaged in the construction industry and prepares financial statements to 30 September each year. The financial statements for the year ended 30 September 2015 are shortly to be authorised for issue. The
following events are relevant to these financial statements:
On 1 August 2015, Delta purchased a machine from a supplier located in a country whose local currency is the groat. The agreed purchase price was 600,000 groats, payable on 31 October 2015. The asset was modified to suit Delta’s purposes at a cost of $30,000 during August 2015 and brought into use on 1 September 2015. The directors of Delta estimated that the useful economic life of the machine from date of first use was five years.
Relevant exchange rates were as follows:
– 1 August 2015 – 2·5 groats to $1.
– 1 September 2015 – 2·4 groats to $1.
– 30 September 2015 – 2·0 groats to $1.
– 31 October 2015 – 2·1 groats to $1.
Answer
The machine and the associated liability would be recorded in the financial statements using the rate of exchange in force at the transaction date – 2·5 groats to $1. Therefore the initial carrying amount of both items is $240,000 (600,000/2·5). The liability is a monetary item so it would be retranslated at the year end of 30 September 2015 using the closing rate of 2 groats to $1 at $300,000 (600,000/2) and shown as a current liability. The exchange difference of $60,000 ($300,000 – $240,000) is recognised in profit or loss – in this case a loss.
The machine is a non-monetary asset measured under the cost model and so is not retranslated as the exchange rate changes. The modification costs of $30,000 are added to the cost of the machine to give a total cost figure of $270,000.
The machine is depreciated from 1 September 2015 (the date it is brought into use) and so the depreciation for the year ended 30 September 2015 is $4,500 ($270,000 x 1/5 x 1/12). The machine will be shown as a non-current asset at a closing carrying value of $265,500 ($270,000 – $4,500).
Examiners feedback
This question was generally well answered by the majority of candidates attempting it. However a significant minority of candidates made a careless error of multiplying the foreign currency (groat) figure to convert into $ rather than dividing it. A smaller minority of candidates seemed unaware of the distinction
between monetary and non-monetary items in a ‘foreign currency context’. Therefore there were some examples of the ‘re-translation’ of PPE, which was not appropriate. Ar minority of candidates incorrectly stated that the exchange differences on re-translation should be recognised in other comprehensive income rather than profit or loss.
ACCA Past question papers Dec 2016 (7 marks)
Question
You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). You have recently produced the final draft of the
financial statements for the year ended 30 September 2016 and these are due to be published shortly. The managing director, who is not an accountant, reviewed these financial statements and prepared a list of queries arising out of
the review.
The notes to the financial statements say that plant and equipment is held under the ‘cost model’. However, property which is owner occupied is revalued annually to fair value. Changes in fair value are sometimes reported in profit or loss but usually in ‘other comprehensive income’. Also, the amount of depreciation charged on plant and equipment as a percentage of its carrying amount is much higher than for owner occupied property. Another note says that property we own but rent out to others is not depreciated at all but is revalued annually to fair value. Changes in value of these properties are always reported in profit or loss. I thought we had to be consistent in our treatment of items in the accounts. Please explain how all these treatments comply with relevant reporting standards.
Answer
The accounting treatment of the majority of tangible non-current assets is governed by IAS 16 – Property, Plant and Equipment (PPE). IAS 16 states that the accounting treatment of PPE is determined on a class by class basis. For this
purpose, property and plant would be regarded as separate classes. IAS 16 requires that PPE is measured using either the cost model or the revaluation model. This model is applied on a class by class basis and must be applied consistently within a class. IAS 16 states that when the revaluation model applies, surpluses are recorded in other comprehensive income, unless they are cancelling out a deficit which has previously been reported in profit or loss, in which case it is reported in profit or loss.
Where the revaluation results in a deficit, then such deficits are reported in profit or loss, unless they are cancelling out a surplus which has previously been reported in other comprehensive income, in which case they are reported in other comprehensive income. According to IAS 16, all assets having a finite useful life should be depreciated over that life. Where property is concerned, the only depreciable element of the property is the buildings element, since land
normally has an indefinite life. The estimated useful life of a building tends to be much longer than for plant. These two reasons together explain why the depreciation charge of a property as a percentage of its carrying amount tends to be much lower than for plant. Properties which are held for investment purposes are not accounted for under IAS 16, but under IAS 40 – Investment Property.
Under the principles of IAS 40, investment properties can be accounted for under a cost or a fair value model. We apply the fair value model and thus our investment properties are revalued annually to fair value, with any changes being reported in profit or loss.
Feedback
All students had answered this reasonably well.
ACCA Past question papers June 2017 (8 marks)
Question
Epsilon prepares financial statements to 31 March each year. The following events have occurred which are relevant to the year ended 31 March 2017:
(i) On 1 April 2016, Epsilon purchased a new head office property for $60 million. On 1 April 2016, Epsilon leased out the top three floors of the property to a third party on a long-term operating lease. The annual rental receivable by Epsilon was $2 million, starting on 31 March 2017. The top three floors of the property were capable of being sold in a separate transaction. On 1 April 2016, the directors of Epsilon estimated that the initial cost of the property should be allocated as follows for accounting purposes:
$ million
Top three floors of building 15
Remainder – buildings component 20
Remainder – land component 25
–––
Total initial cost 60
–––
On 31 March 2017, the property had an estimated total fair value of $64 million. The directors consider that 25% of this fair value was attributable to the top three floors of the property. The directors of Epsilon wish to use the cost model for measuring property, plant and equipment and the fair value model for measuring investment property. Epsilon depreciates the buildings component of properties over an estimated useful life of 50 years, with no estimated residual value. The rental payable to Epsilon on 31 March 2017 was paid in accordance with the terms of the lease.
Answer
The property purchased for $60 million is a mixed-use property. The property is being partly owner occupied and partly used for investment purposes. IAS 40 Investment Property states that where a property is held for mixed-use in this way, then the portions should be accounted for separately if they could be sold separately. This applies here. The investment property has an ‘effective original cost’ of $15 million. Since the fair value model is being used to measure investment property, the investment property will not be depreciated but remeasured to fair value at 31 March 2017, with gains or losses on remeasurement being recognised in profit or loss. Therefore the year-end carrying
amount of the investment property will be $16 million ($64 million x 25%) and a
remeasurement gain of $1 million ($16 million – $15 million) will be recognised in profit or loss.
The investment property will be shown as a non-current asset in the statement of financial position. Since the lease is an operating lease, Epsilon (as lessor) will recognise rental income of $2 million in profit or loss for the year ended 31 March 2017. The remainder of the property, having an original cost of $45 million ($60 million –$15 million), will be accounted for as property, plant and equipment and measured under the cost model.
The buildings component will be depreciated and the charge for the year ended 31 March 2017 will be $400,000 ($20 million x 1/50). This charge will be recognised in profit or loss. The carrying amount of the property, plant and equipment at 31 March 2015 will be $44·6 million ($45 million – $400,000). This will be shown as a non-current asset in the statement of financial position
Feedback
Most candidates were able to correctly identify that the top three floors of the head office property should be accounted for separately from the rest as an investment property (part (b(i)). However a significant minority of candidates charged depreciation of the investment property despite being told in the question
that the fair value model was to be adopted for the investment property. Other candidates recognised the change in the fair value of the investment property in other comprehensive income rather than profit or loss. Both these issues indicate a lack of understanding of the implications of adopting the fair value model for investment properties.
ACCA Past question papers June 2018 (6 marks)
Question
When reading the accounting policies note in the consolidated financial statements I notice that we measure all of our freehold properties using a fair value model but that we measure our plant and equipment using a cost model. I
further notice that both of these asset types are shown in the ‘property, plant and equipment’ figure which is a single component of non-current assets in the consolidated statement of financial position. It makes no sense to me that assets which are shown as property, plant and equipment are measured inconsistently. If it’s OK to measure different parts of property, plant and equipment using two different measurement models, why not use the fair value model for the more readily accessible properties and use the cost model for the properties in remote locations to save on time and cost?
Answer
IAS 16 – Property, Plant and Equipment (PPE) – allows (but does not require) entities to revalue its PPE to fair value. However, it requires that the measurement model used (cost or fair value) for PPE should be consistent on a class by class basis. A class of PPE is a grouping of assets of a similar nature and use in an entity’s operations. Based on this definition, it is likely that property (or ‘land and buildings’) would form one distinct class of PPE and that plant and equipment would form another class.
Therefore it is perfectly consistent with IFRS for property to be measured under the revaluation (fair value) model and plant and equipment to be measured under the cost model. However, it would be inappropriate to ‘cherry pick’ or apply a ‘mixed measurement model’ to property (or land and buildings) based simply on its geographical location. This prevents entities only revaluing items which have increased in value and leaving other items at their (depreciated) cost.
If we do use the fair value model, then we need to make sure we revalue with sufficient regularity to ensure that the carrying amount of the revalued asset is a true reflection of its current value.
Feedback
Many candidates seemed to assume that the freehold properties referred to in the scenario were investment properties, and raised issues from IAS40. Where such issues were relevant to the question asked, these were given credit.
ACCA Past question papers Dec 2018 (16 marks)
Question
Epsilon is an entity which prepares financial statements to 30 September each year.
(a) Purchase of machine
On 1 April 2018, Epsilon accepted delivery of a large and complex machine from an overseas supplier. The agreed purchase price for the machine was 20 million francs – the functional currency of the supplier. Under the terms of the agreement with the supplier 12·6 million francs was payable on 31 July 2018, with the balance of 7·4 million francs being payable on 30 November 2018. The payment due on 31 July 2018 was made in accordance with the terms of the agreement. Epsilon does not use hedge accounting. On 1 April 2018, Epsilon incurred direct costs of $250,000 in installing the machine at its premises. Although the machine was ready for use from 1 April 2018, Epsilon did not bring the machine into use until 30 April 2018. During April 2018 Epsilon incurred costs of $200,000 in training relevant staff to use the machine.
The directors of Epsilon estimate that the machine is capable of being usefully employed in the business until 31 March 2023, and that it will have no residual value at that date.
(b) Decommissioning
On 31 March 2023, Epsilon will be legally required to decommission the machine using the original supplier. The directors of Epsilon estimate that the cost of safely decommissioning the machine on 31 March 2023 will be 3 million francs.
Note: A relevant annual rate to be used in any discounting calculations is 8% and the appropriate discount factor
is 0·681.
(c) Impairment review
During the final few months of the accounting period ending on 30 September 2018, Epsilon experienced difficult trading conditions. These difficulties did not affect the ability of Epsilon to operate as a going concern. In an impairment review of the machine at 30 September 2018, the directors of Epsilon estimated that the machine’s recoverable amount was $2·5 million.
Relevant exchange rates (francs to $1) are as follows:
– 1 April 2018 – 10 francs to $1.
– 30 April 2018 – 9·5 francs to $1.
– 31 July 2018 – 9 francs to $1.
– 30 September 2018 – 8 francs to $1.
– Average rate for the period from 1 April 2018 to 30 September 2018 – 9·2 francs to $1.
Answer
(a) Purchase of machine
The cost of purchasing the machine from the foreign supplier (20 million francs) will initially be recognised in the financial statements using the rate of exchange at the date of delivery (10 francs to $1). Therefore $2 million (20 million/10) will be included in Epsilon’s property, plant and equipment (PPE). PPE is a non-monetary item, so even though the exchange rate (francs to the $) fluctuates during the
accounting period, this will cause no change to the $2 million carrying amount. 1⁄2
The liability to pay the supplier will initially be recognised at $2 million (the $ cost of the machine). The part payment of the liability on 31 July 2018 will be recorded using the rate of exchange on that date. Therefore $1,400,000 (12,600,000/9) will be credited to cash and debited to the liability.
The closing liability is a monetary item, so on 30 September 2018 it needs to be re-measured using the rate of exchange in force at that date. 1⁄2 (principle)
The amount of the closing liability in $ is $925,000 (7·4 million /8). This will be shown as a current liability. Due to the strengthening of the franc against the $, there will be an exchange loss on the re-measurement of the liability which must be recognised in the statement of profit or loss. The amount of the exchange loss is $325,000 ($925,000 – ($2,000,000 – $1,400,000)). The $250,000 cost of installing the machine is a directly attributable cost of getting the machine
ready for use and this amount will be added to the cost of PPE.
The costs of $200,000 incurred in training staff to use the machine are revenue items and cannot be included in the cost of PPE. These must be charged in the statement of profit or loss as an expense.
(b) Decommissioning
Epsilon has a legal obligation to dispose of the machine safely at the end of its useful life. This obligation is reliably measurable and so it must be recognised as a provision on 1 April 2018. The provision is recognised at the present value of the estimated future expenditure of 3 million francs (3 million x 0·681 = 2,043,000 francs).
The provision is added to the cost of the asset using the rate of exchange on 1 April 2018 (10 francs to $1). Therefore $204,300 (2,043,000/10) is added to the cost of PPE.
As the date for payment of the disposal costs draws closer the provision increases. This ‘unwinding of the discount’ is shown as a finance cost in the statement of profit or loss.
The finance cost in francs is 81,720 (2,043,000 x 8% x 6/12). This will be translated into $ using the average rate for the period from 1 April 2018 to 30 September 2018 (9·2 francs to $1). Therefore the charge to the statement of profit or loss for the finance cost will be $8,883 (81,720/9·2).
The closing provision for decommissioning is a monetary item, so on 30 September 2018 it needs to be re-measured using the rate of exchange in force at that date. The provision in francs is 2,124,720 (2,043,000 + 81,720). The $ equivalent of this is $265,590 (2,124,720/8). The provision will be shown as a non-current liability in the statement of financial position at 30 September 2018.
Due to the strengthening of the franc against the $, there will be an exchange loss on the re- measurement of the provision which must be recognised in the statement of profit or loss. The amount of the exchange loss is $52,407 ($265,590 – ($204,300 + $8,883)).
(c) Impairment review
The total initial cost of the machine will be $2,454,300 ($2 million + $250,000 + $204,300). The machine will be depreciated from 1 April 2018 over its five-year useful life, so the depreciation charge for the year ended 30 September 2018 will be $245,430 ($2,454,300 x 1/5 x 6/12). The closing carrying amount of the machine in PPE will be $2,208,870 ($2,454,300 – $245,430). This will be shown as a non-current asset in the statement of financial position at 30 September
2018. The difficult trading conditions experienced by Epsilon in the final few months of the financial year is an indicator that the machine could have suffered impairment. Therefore a review is required. However, since the recoverable amount ($2·5 million) of the machine is higher than its carrying amount, no impairment loss needs to be recorded.
Feedback
On the whole answers to this question were of a satisfactory standard. However some candidates who were clearly displaying good knowledge of the subject matter lost marks by not fully explaining the accounting treatments they were showing. Particular examples of this included:
x Not explaining why the installation costs were capitalised but the staff costs were expensed.
x Not explaining why the asset would be depreciated from 1 April 2018, the date it was ready for use.
x Not stating that the adverse trading conditions experienced by Alpha were indications that the asset might be impaired.
x Not stating where in the financial statements amounts they correctly computed would be shown (e.g. non-current assets and current or non-current liabilities).
As already stated much of the technical knowledge displayed by candidates was of a satisfactory standard. However a fairly common error/omission was failure to appreciate that the decommissioning provision was a monetary item that would be affected by exchange fluctuations.
ACCA Past question papers June 2019 (8 marks)
Question
On 1 April 20X6, Gamma purchased a machine from a foreign supplier. The cost of the machine was 900,000 dinars. Gamma paid this amount to the supplier on 30 June 20X6. The estimated useful life of the machine at 1 April 20X6 was eight years. However, the machine contains a component which will need replacing after four years. On 1 April 20X6, the directors of Gamma estimated that 30% of the original cost of the machine was attributable to this component. Relevant exchange rates (dinars to $1) were as follows:
Date Exchange rate (dinars to $1)
1 April 20X6 3
30 June 20X6 2·5
31 March 20X7 2·4
Gamma uses the cost model to measure all of its property, plant and equipment.
Answer
The machine would originally be recognised in the financial statements on 1 April 20X6 using the rate of exchange in force at that date (3 dinars to $1). Therefore the initial carrying amount of the machine would be $300,000 (900,000/3). This will also be the initially recognised amount of the associated liability. When the liability is settled on 30 June 20X6, Gamma will have to pay $360,000 (900,000/2·5). The
difference of $60,000 ($360,000 – $300,000) between the original liability and the settlement amount will be an exchange loss which will be recognised in the statement of profit or loss as an operating expense.
Because the machine is a non-monetary item which is measured under the cost model, its carrying amount will not be affected by future currency fluctuations.
Because part of the machine will need to be replaced after four years, depreciation needs to be accounted for by splitting the asset into two depreciable components.
The amount of the initial carrying amount which relates to the component which needs replacing after four years is $90,000 (($300,000 x 30%). Depreciation on this component in the year ended 31 March 20X7 will be $22,500 ($90,000 x 1⁄4).
Depreciation on the remainder of the asset for the year ended 31 March 20X7 will be $26,250 (${300,000 – $90,000} x 1/8).
The closing carrying amount of the asset which will be included as a non-current asset within property, plant and equipment will be $251,250 ($300,000 – $22,500 – $26,250)..
Feedback
Answers were generally of a highly satisfactory standard. Fairly common errors
committed by a significant minority of candidates included:
x Calculating the $ cost of the asset incorrectly by multiplying the dinar amount by the relevant exchange rate rather than dividing it.
x Treating the required component replacement after four years incorrectly by making a provision rather than applying component depreciation.
ACCA Past question papers June 2022 (10 marks)
Question
Using the information above, explain and show how the transactions described should be accounted for in the financial statements of Gamma for the year ended 31 March 20X5. Your answer to (a) should NOT include discussion of any ethical issues.
Notes:
• Marks will be awarded for BOTH figures AND explanations.
Answer
The relevant standard is IAS 16 – Property, Plant and Equipment (PPE). Where PPE is revalued and the revaluation shows a surplus, then, unless the surplus is eliminating a previous revaluation deficit on the same asset, the surplus is recognised in other comprehensive income rather than profit or loss (principle).
Since this is a first time revaluation, then a surplus of $10 million ($30 million – $20 million) will be recognised in other comprehensive income.
Regardless of future potential increases in value, assets which are revalued still need to be depreciated over their estimated future useful lives (principle).
Land generally has an indefinite life, so only the buildings element of the property needs to be depreciated (principle).
This means that the depreciation charge on the property for the year ended 31 March 20X5 will be $0·9 million ($18 million x1/20). $0·9 million will be charged as an expense in the statement of profit or loss.
The carrying amount of the property at 31 March 20X5 will be $29·1 million ($30 million – $0·9 million). This will be presented as part of non-current assets in the statement of financial position.
Under the principles of IAS 12 – Income Taxes – a deferred tax liability must be recognised on the revaluation of an asset even if there is no intention to dispose of the asset (principle).
IAS 12 requires that a deferred tax liability be recognised on the difference between the carrying amount of an asset and its tax base (principle).
So for this property, the deferred tax liability prior to its revaluation will be $5 million (25% x $20 million (– $0 tax base)).
After the revaluation, the deferred tax liability will increase to $7·5 million (25% x $30 million (– $0 tax base)).
The increase of $2·5 million following the revaluation will be debited to other comprehensive income.
The net credit to other comprehensive income as a result of the revaluation will be $7·5 million ($10 million – $2·5 million). This net credit will be recognised as a revaluation surplus in the statement of financial position as part of ‘other components of equity’.
The deferred tax liability on 31 March 20X5 will be $7·275 million ($29·1 million x 25%). This will be presented as a non-current liability in the statement of financial position.
The reduction in the deferred tax liability between 1 April 20X4 and 31 March 20X5 will be $0·225 million ($7·5 million – $7·275 million). This will be shown as a credit to the income tax expense in the statement of profit or loss.
Tutorial note: Some candidates may mention the option given in IAS 16 for entities which measure PPE using the revaluation model to make a transfer between the revaluation surplus and retained earnings. This transfer is based on the difference between depreciation actually charged on the revalued asset – in this case $0·9 million – and the depreciation which would have been charged had the asset continued to be measured at historical cost. This amount would have been $0·5 million ($10 million x 1/20), so the gross transfer for the year ended 31 March 20X5 would have been $0·4 million ($0·9 million – $0·5 million). Where deferred tax is taken into consideration, the transfer is made net of attributable taxation
5
charged had the asset continued to be measured at historical cost. This amount would have been $0·5 million ($10 million x 1/20), so the gross transfer for the year ended 31 March 20X5 would have been $0·4 million ($0·9 million – $0·5 million). Where deferred tax is taken into consideration, the transfer is made net of attributable taxation. The accounting entry in this case would be:
$m $m
Credit retained earnings ($0·4 million x (100 – 25)%) 0·30 Debit revaluation reserve 0·30
Candidates who take this approach will be awarded a maximum of 3 additional marks (but the total for attachment 2 cannot exceed 10 marks).
Feedback
Answers to issue two above – the revaluation of the building - were also relatively disappointing. A number of candidates made inappropriate references to the provision of IAS 40 – Investment Property. There was no indication in the question that the property was an investment property and so these references attracted no marks. There were also inappropriate references made to the requirements of IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors. Paragraph 17 of IAS 8 makes it clear that the revaluation of owner-occupied properties is subject to the provisions of IAS 16 – Property, Plant and Equipment – rather than IAS 8. Therefore references to IAS 8 did not attract any marks either. Even where references were correctly made to IAS16, a surprising number of candidates stated that the revaluation surplus should be recognised in profit or loss, rather than in other comprehensive income. The majority of candidates did not appear to be aware that the revaluation of an asset created a taxable temporary difference on which deferred tax should be recognised. Even where this general appreciation was apparent, very few candidates appreciated that deferred tax on the original surplus would be recognised in other comprehensive income, whilst the deferred tax implications of the subsequent depreciation would be shown in profit or loss.
ACCA Past question papers June 2023 (21 marks)
Question
Theta, a listed entity, prepares financial statements to 30 June each year. You are a trainee accountant employed by Theta and report to the finance director (FD) of Theta. One of your key responsibilities is to prepare the first draft of Theta’s published financial statements. You have recently received an email from the FD regarding the financial statements for the year ended 30 June 20X5. You are unsure how to respond to this email and have asked a friend of yours for advice. This friend is a qualified accountant who is not employed by Theta.
The following exhibits, available on the left-hand side of the screen, provide information relevant to the question:
|
1. |
Email – an email from the FD. |
|
2. |
Attachment to the email – details information relating to the construction of new plant, a loan to finance the construction, and environmental damage. |
This information should be used to answer the question requirements within your chosen response option(s).
As you will know, we are just about to begin the preparation of the published financial statements for the year ended 30 June 20X5. It is very important that the upcoming set of financial results show a favourable financial performance. This will reflect well on the whole finance department, including you. I want these statements to report as high a profit as possible to satisfy the shareholders and boost the share price. I understand that you do not currently own any shares in Theta. It would be advantageous for you to purchase some shares immediately, before the latest results are published. If the results show a high profit, then the share price is likely to rise.
I would like you to prepare a draft of the financial statements for my review and approval. There is a relatively complex set of transactions which have occurred in the year ended 30 June 20X5 which you may be unsure how to deal with. These transactions are described in the attachment to this email. I have also included the way in which I would like you to deal with them in the financial statements. You should be aware that your annual performance appraisal, which I am responsible for, is due shortly
Attachment to email
We have constructed a plant and I have provided details of the costs of construction, a loan taken to finance the costs of construction and some details of environmental damage arising from the construction.
Cost of plant
On 1 January 20X5, we began to construct a plant which will produce fertiliser. This fertiliser can be sold to entities in the agricultural industry. We completed construction of the plant on 1 March 20X5 and then provided relevant employees with a comprehensive training course on the plant’s operating method.
We could have begun to operate the plant from 1 April 20X5 but prior to beginning operations, we held an opening ceremony in late April 20X5 and invited a large number of potential customers to demonstrate that the plant was ready for production.
Although we started production on 15 May 20X5, this was only at a small fraction of the plant’s operating capacity. We will begin to operate the plant at full capacity from 1 July 20X5.
The costs which we have incurred on this construction project to date and which I want you to include as part of property, plant and equipment (PPE) in the statement of financial position at 30 June 20X5 are as follows:
$’000
The estimated useful life of the plant is 20 years, and we should start to depreciate it on from 1 July 20X5 when it is operating at full capacity.
Loan
On 1 December 20X4, we borrowed $8 million to partly finance construction of the plant. The lender charged a lending fee of $200,000, so we actually received a net sum of $7·8 million on 1 December 20X4. There is no interest payable on this borrowing, but we will repay $8·52 million on 30 November 20X5. I want you to show a loan figure of $8 million in the statement of financial position as at 30 June 20X5, and the lending fee of $200,000 as an additional component of PPE. Do not account for the extra amount repayable on 30 November 20X5.
Environmental damage
The construction of the plant caused some environmental damage. When we stop using the plant in 20 years’ time, the cost of rectifying this damage is estimated to be $10 million. There is no legal obligation for us to rectify this damage. However, we have a reputation for rectifying all environmental damage we have caused. Since there is no legal obligation, you can forget about it from the point of view of the financial statements for the current year. A colleague of yours has stated that an annual discount rate appropriate to the risks associated with this construction project is 10% and therefore the present value of $1 payable in 20 years’ time is approximately 15 cents. However, ignore all this – I do not want any recognition of this potential future cost at all.
Requirements
(a) Using the information in exhibit 2, explain and show how the transactions described there should be accounted for in the financial statements of Theta for the year ended 30 June 20X5.
Notes:
- Marks will be awarded for BOTH figures AND explanations.
- Ignore taxation.
- Your answer to this part should NOT discuss any ethical issues.
(21 marks)
Answer
Attachment to email
The relevant standard is IAS 16 – Property, Plant and Equipment (PPE). IAS 16 states that the cost of an item of PPE should be its purchase price plus any costs directly attributable to bringing the asset to the location and condition for it to be capable of operating in the manner intended by management (principle).
Under this principle, the materials used in the construction of the plant should be included in the cost of PPE and also the production overheads directly related to its construction.
However, IAS 16 does not allow general administrative overheads to be included as part of PPE. Such overheads ($1 million in this case) should be recognised in the statement of profit or loss as an operating expense.
IAS 16 allows the cost of employee benefits payable to construction staff to be included in the cost of PPE, but only those costs incurred during the construction period, which is January and February 20X5. Therefore $1 million (2 x $500,000) will be included in PPE whilst the other $2 million will be recognised in the statement of profit or loss as an operating expense.
The costs of training staff to operate the new plant cannot be recognised in PPE since they are specifically disallowed by IAS 16. These costs ($600,000) should be recognised in the statement of profit or loss as an operating expense.
The cost of $200,000 to test the operating systems to ensure they are fit for purpose are necessary to enable the plant to be used and should be recognised in PPE.
The costs of an opening ceremony cannot be recognised in PPE and should be recognised in the statement of profit or loss as an operating expense.
Under the principles of IFRS 9 – Financial Instruments – the borrowing is a financial liability measured using the amortised cost method.
The initial carrying amount of the financial liability should be the net proceeds received from the lender of $7·8 million. The borrowing fee should not be included in PPE (principle).
The difference of $720,000 ($8·52 million – $7·8 million) between the initial carrying amount of the borrowing and the final repayment will be a finance (borrowing) cost (principle). In this case, the finance cost for the year ended 30 June 20X5 will be $420,000 ($720,000 x 7/12).
Under the principles of IAS 23 – Borrowing Costs – costs of borrowings taken out to finance the construction of an asset are recognised in PPE during the period in which activities are taking place in order to get the asset ready for use (principle). In this case, the borrowing (finance) costs which are recognised in this way will be those incurred in the three-month period from 1 January 20X5 to 1 April 20X5 of $180,000 ($720,000 x 3/12).
The remaining borrowing costs of $240,000 ($420,000 – $180,000) will be recognised in the statement of profit or loss as a finance cost.
The closing borrowings balance will be $8,220,000 ($7·8 million + $420,000). This will be recognised in the statement of financial position as a current liability.
Under the principles of IAS 37 – Provisions, Contingent Liabilities and Contingent Assets – a provision for the environmental rectification cost is required if there is an obligation arising out of a past event which can be reliably measured.
Although there is no legal obligation to rectify the damage, Theta has, by its reputation, created a constructive obligation and will undertake this expenditure, so a provision is required – sense of the point.
Where the time value of money is material, IAS 37 requires that the provision be measured at the present value of the expected future expenditure (principle). Therefore the provision which should be recognised from 1 March 20X5 (the date construction is completed and the environmental damage caused) and measured at $1·5 million ($10 million x 0·15).
Under the principles of IAS 16 this recognition provision is included as part of the cost of PPE, so an additional $1·5 million is included in PPE.
Therefore the total amount included in the cost of PPE at 30 June 20X5 is $8,880,000 (W1).
Depreciation should be charged from 1 April 20X5, the date the asset is available for use (principle).
Therefore depreciation for the year ended 30 June 20X5 will be $111,000 ($8,880,000 x 1/20 x 3/12).This will be recognised in the statement of profit or loss as an operating expense.
The closing balance of PPE will be $8,769,000 ($8,880,000 – $111,000). This will be recognised as a non-current asset in the statement of financial position.
As the date for payment of the $10 million rectification cost gets closer, the discount unwinds and the unwinding amount is added to the recognised provision (principle).
For the year ended 30 June 20X5, the amount of the unwinding is $50,000 ($1·5 million x 10% x 4/12). $50,000 will be recognised in the statement of profit or loss as a finance cost.
The closing provision will be $1,550,000 ($1·5 million + $50,000). This will be recognised as a non-current liability in the statement of financial position.
Examiners Feedback
This question placed the candidate as a trainee accountant, working for Theta, who was presented with a complex financial reporting issue. The issue involved the construction of a large item of plant and required candidates to identify appropriate costs that could be included in the cost of the plant. The costs of construction of the plant were partly financed by borrowings and the construction caused environmental damage of a sort that Theta had a reputation for rectifying, even though they had no legal obligation to do so.
The trainee accountant was being told by the Finance Director to recognise the transactions in such a way as to maximise reported profits. The trainee was encouraged to buy shares in Theta to take advantage of the potential increase in share price caused by the release of favourable results.
Candidates were required to identify the appropriate financial reporting treatments of the transactions associated with the construction of the plant and explain the ethical issues confronting the trainee as a result of the scenario.
Overall, answers to this question were satisfactory and represented a pleasing improvement on answers to similar questions that have been set in the past. Specific comments relating to candidate performance are as follows:
- There were good descriptions of the general principle of the types of cost that could validly be included in the cost of the asset and the reasons why.
- The issue of the period over which recurring costs (e.g. the salaries of construction workers) could validly be included in the cost of the plant produced answers of varying quality. Capitalisation of salary costs was only appropriate during the two-month construction period (January and February 20X5).
- Many candidates were confused by the computation of the carrying amount of the loan and its associated finance cost. Many candidates did not realize that the $200,000 issue costs should be debited to the initial carrying amount of the loan to show an opening net amount of $7.8 million.
- Most candidates seemed to be aware of the principle that the finance cost of the loan should be treated as part of the cost of the plant during the period in which the asset was being made ready for use. However many failed to correctly apportion the overall finance cost for the period of seven months from the date the loan was taken out until the year-end between the amount included in the cost of the plant and the amount taken to profit or loss. As the suggested answer indicates, there is an argument that the ‘capitalisation period’ should either be the two-month construction period (January and February 20X5) or a three month period which also includes March 20X5, the month in which employee training takes place. Either treatment was given full marks if correctly applied.
- Calculation and initial recognition of the appropriate environmental provision was generally of a satisfactory standard. However the issue of the on-going treatment of the provision in the statement of financial position, and the finance cost relating to the unwinding of the present value calculation relating to the initial computation of the provision was ignored by a significant number of candidates.
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