3.2 Property, Plant and Equipment, Borrowing Costs, and Impairment

Property, Plant and Equipment, Borrowing Costs, and Impairment

Property, plant and equipment carries four items in the FAR TOS and feeds several more through depreciation, revaluation, and impairment. This section covers what may be capitalized under PAS 16, the capitalization of borrowing costs under PAS 23, the cost and revaluation models, depreciation methods and component depreciation, and PAS 36 impairment of single assets and cash-generating units, ending with a full revaluation example.

---

1. PAS 16: Initial Measurement and Capitalizable Costs

Under PAS 16 paragraph 6, Property, Plant and Equipment (PPE) are tangible items that:

1. Are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and
2. Are expected to be used during more than one reporting period.

Components of Initial Cost

Under PAS 16 paragraph 16, the initial cost of an item of PPE comprises:

1. Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
2. Directly attributable costs necessary to bring the asset to the location and condition capable of operating in the manner intended by management:
   • Site preparation costs;
   • Initial delivery, freight, and handling costs;
   • Installation and assembly costs;
   • Professional fees (architects, structural engineers);
   • Costs of testing functionality.
   • Proceeds from Testing: Under the amendments to PAS 16 (Proceeds before Intended Use), proceeds from selling items produced while bringing PPE to the location and condition necessary for intended operation (e.g., sample specimens produced during trial runs), along with the production costs of those items, must be recognized in profit or loss. Entities are strictly prohibited from deducting testing sales proceeds from the capitalized cost of PPE.
3. Decommissioning and Site Restoration Obligations: The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. The entity recognizes this obligation when acquiring the asset or as a consequence of using it for purposes other than producing inventories. The obligation is recognized as a liability under PAS 37 (Provisions) at present value, with an identical amount capitalized into the cost of the asset.

$\text{Initial Asset Cost} = \text{Cash Purchase Price} + \text{Directly Attributable Costs} + \text{Present Value of Restoration Obligation}$

Unwinding of the Discount: In subsequent years, the decommissioning provision is accreted to its expected settlement amount. The accretion is debited to Finance Cost (Interest Expense) in profit or loss and credited to Provision, never capitalized into PPE.

---

2. Borrowing Costs Capitalization (PAS 23)

Under PAS 23, borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset must be capitalized as part of the cost of that asset. A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale (e.g., manufacturing plants, power generation facilities, infrastructure, development properties).

Measurement of Capitalizable Borrowing Costs

• Specific Borrowings: $\text{Capitalizable Cost} = \text{Actual Interest Incurred} - \text{Investment Income on Temporary Reinvestment of Funds}$
• General Borrowings: When funds are borrowed generally and used to finance a qualifying asset, the capitalizable amount is calculated by applying a capitalization rate (the weighted average of the borrowing costs applicable to outstanding general borrowings during the period) to the average accumulated expenditures on the asset.

$\text{Capitalization Rate} = \frac{\text{Total Borrowing Costs on General Borrowings}}{\text{Total Principal of General Borrowings}}$ $\text{Capitalizable General Interest} = \text{Average Accumulated Expenditures} \times \text{Capitalization Rate}$

Ceiling Rule: The amount of borrowing costs capitalized during a period cannot exceed the actual borrowing costs incurred by the entity during that period.

Capitalization Window

• Commencement: Capitalization begins when: (1) expenditures for the asset are being incurred; (2) borrowing costs are being incurred; and (3) activities necessary to prepare the asset for its intended use or sale are actively in progress.
• Suspension: Capitalization must be suspended during extended periods in which active development is interrupted.
• Cessation: Capitalization permanently ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.

---

3. Subsequent Measurement: Cost Model vs. Revaluation Model

PAS 16 provides an accounting policy choice applied consistently across an entire class of PPE:

1. Cost Model: Carrying amount = Cost less accumulated depreciation and accumulated impairment losses.
2. Revaluation Model: Carrying amount = Fair value at the date of revaluation less subsequent accumulated depreciation and subsequent impairment losses.

Accounting Mechanics of the Revaluation Model

Revaluations must be carried out with sufficient regularity so that the carrying amount does not differ materially from fair value. When an item is revalued, the accumulated depreciation at the revaluation date is treated under one of two methods:

• Elimination Method: Accumulated depreciation is credited and cleared against the gross carrying amount of the asset; the net carrying amount is then adjusted to the revalued fair value.
• Proportional Restatement Method: Both the gross carrying amount and the accumulated depreciation are restated proportionately so that the resulting net carrying amount equals the revalued amount.

Treatment of Revaluation Surplus and Deficits

• Initial Upward Revaluation: Recognized in Other Comprehensive Income (OCI) and accumulated in equity under the heading Revaluation Surplus.
• Initial Downward Revaluation (Deficit): Recognized immediately in Profit or Loss as an impairment/revaluation loss.
• Subsequent Revaluations:
  • A subsequent downward revaluation is debited to OCI to the extent of any existing credit balance in Revaluation Surplus for that same asset; any excess is expensed in profit or loss.
  • A subsequent upward revaluation is credited to profit or loss to the extent of previously recognized losses in profit or loss; any excess is credited to OCI (Revaluation Surplus).

Realization of Revaluation Surplus

The revaluation surplus included in equity may be transferred directly to Retained Earnings (never through profit or loss):

1. Piecemeal Transfer (through use): The difference between depreciation based on the revalued carrying amount and depreciation based on the asset's original historical cost is transferred annually from Revaluation Surplus to Retained Earnings.
2. Lump-Sum Transfer (upon derecognition): When the asset is retired or disposed of, the entire remaining balance of Revaluation Surplus is transferred directly to Retained Earnings.

---

4. Depreciation Methods and Component Depreciation

Depreciable amount is cost (or revalued amount) less residual value. Depreciation is allocated on a systematic basis over the asset's useful life using methods that reflect the pattern in which future economic benefits are consumed:

Component Depreciation

Under PAS 16 paragraph 43, each part of an item of PPE with a cost that is significant in relation to the total cost of the item must be depreciated separately (e.g., the airframe and engines of an aircraft; the roof, elevators, and structural frame of a commercial building).

Changes in Estimates

Useful life, residual value, and depreciation methods must be reviewed at least at each financial year-end. Changes are accounted for as changes in accounting estimates under PAS 8, applied prospectively without adjusting prior periods.

---

5. PAS 36: Impairment of Assets

An asset is impaired when its carrying amount exceeds its recoverable amount.

Recoverable Amount

$\text{Recoverable Amount} = \max(\text{Fair Value Less Costs of Disposal [FVLCOD]}, \text{Value in Use [VIU]})$

• FVLCOD: Price that would be received to sell an asset in an orderly transaction between market participants, less direct incremental costs of disposal.
• Value in Use (VIU): Present value of estimated future pre-tax cash flows expected to be derived from the continuing use of the asset and from its ultimate disposal at the end of its useful life.

Cash-Generating Units (CGUs) and Allocation of Impairment Loss

A Cash-Generating Unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets. When an impairment loss arises for a CGU, it is allocated in the following strict hierarchy:

1. First, reduce any goodwill allocated to the CGU to zero.
2. Second, allocate the remaining loss pro rata to the other non-current assets of the CGU based on the relative carrying amount of each asset.

The Asset Floor Constraint

In allocating an impairment loss, the carrying amount of an individual asset cannot be reduced below the highest of:

• Its individual Fair Value Less Costs of Disposal (if measurable);
• Its individual Value in Use (if determinable); and
• Zero.

Any unallocated impairment loss resulting from this floor constraint is reallocated pro rata to the remaining eligible assets in the CGU.

Reversal of Impairment Losses

Entities assess at each reporting date whether an impairment loss recognized in prior periods may no longer exist or may have decreased:

• Goodwill: Impairment losses recognized for goodwill are strictly irreversible under any circumstances under PAS 36 paragraph 124.
• Other Assets: Impairment reversals are recognized immediately in profit or loss (or OCI for revalued assets). The increased carrying amount cannot exceed the carrying amount that would have been determined (net of amortization or depreciation) had no impairment loss been recognized in prior years.

---

6. Comprehensive Worked Example: PPE Revaluation and Subsequent Disposal

Cebu Industrial Corp. acquired a specialized production facility on January 1, 2024, for PHP 10,000,000. The facility had an estimated useful life of 20 years with zero residual value and is depreciated on a straight-line basis. The company adopts the revaluation model for this class of PPE and utilizes the elimination method.

Fiscal Year 2024 & 2025: Historical Depreciation

• Annual Depreciation: $\frac{\text{PHP }10{,}000{,}000}{20} = \text{PHP }500{,}000$
• Carrying Amount at December 31, 2025 (after 2 years): $\text{PHP }10{,}000{,}000 - \text{PHP }1{,}000{,}000 = \text{PHP }9{,}000{,}000$

December 31, 2025: First Revaluation

On December 31, 2025, an independent appraisal establishes a fair value of PHP 11,700,000 (remaining useful life remains 18 years).

Carrying Amount before Revaluation:      PHP  9,000,000
Revalued Fair Value:                     PHP 11,700,000
Revaluation Surplus (credited to OCI):   PHP  2,700,000

Journal Entries under Elimination Method:

1. Accumulated Depreciation               1,000,000
       Building                                       1,000,000
   (To eliminate accumulated depreciation against gross carrying amount)

2. Building                               2,700,000
       Revaluation Surplus (OCI)                      2,700,000
   (To adjust net carrying amount to fair value)

Fiscal Year 2026: Depreciation and Piecemeal Transfer

• New Annual Depreciation: $\frac{\text{PHP }11{,}700{,}000}{18} = \text{PHP }650{,}000$
• Historical Baseline Depreciation: PHP 500,000
• Excess Depreciation: $\text{PHP }650{,}000 - \text{PHP }500{,}000 = \text{PHP }150{,}000$

Journal Entries for 2026:

1. Depreciation Expense                     650,000
       Accumulated Depreciation                         650,000
   (To record depreciation on revalued amount)

2. Revaluation Surplus                      150,000
       Retained Earnings                                150,000
   (Piecemeal realization of revaluation surplus)

Carrying amount of Facility at December 31, 2026: $\text{PHP }11{,}700{,}000 - \text{PHP }650{,}000 = \text{PHP }11{,}050{,}000$. Remaining Revaluation Surplus in equity: $\text{PHP }2{,}700{,}000 - \text{PHP }150{,}000 = \text{PHP }2{,}550{,}000$.