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FRS 15, Tangible fixed assets
by Paul Robins
01 Sep 1999
This month's article deals with Financial Reporting Standard (FRS) 15, Tangible fixed assets. FRS 15 was issued on 15th February 1999 and is specifically examinable at the December 1999 diet for the first time. The new standard applies to all accounting periods ending after 23rd March 2000, although earlier application is encouraged. FRS 15 is the first FRS to deal comprehensively with the measurement and depreciation of tangible fixed assets. Those parts of the FRS that deal with depreciation effectively supersede SSAP 12 and that SSAP has been withdrawn. Small companies that apply the FRSSE are exempt from the requirements of FRS 15 although the FRSSE will doubtless be amended to incorporate relevant provisions of FRS 15 in due course. Investment properties that are accounted for in accordance with SSAP 19, Accounting for investment properties are not covered by FRS 15 and SSAP 19 remains in force for such properties. It is likely that a future FRS will address the issue of updating SSAP 19.
FRS 15 defines tangible fixed assets as follows:
"Assets that have physical substance and are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes on a continuing basis in the reporting entity's activities."
Two particularly key aspects of the definition are the fact the assets have physical substance, differentiating tangible fixed assets from intangible fixed assets, and that the assets are held for use on a continuing basis, differentiating fixed assets from current assets.
Broadly speaking, FRS 15 deals with three issues regarding tangible fixed assets:
their initial measurement;
their revaluation;
their depreciation.
The initial measurement of a tangible fixed asset
FRS 15 requires that a tangible fixed asset should initially be measured at its cost. The FRS 15 provisions regarding the measurement of cost apply whether the asset is purchased or whether it is constructed. Broadly speaking, `cost' is taken as the cost of purchase net of any trade discounts plus any costs directly attributable to bringing it into working condition for its intended use. Directly attributable costs comprise:
the labour costs of own employees arising directly from the construction or acquisition of the tangible fixed asset;
the incremental costs to the entity that would have been avoided only if the tangible fixed asset had not been constructed or acquired.
It follows from this that administration and other general overhead costs would be excluded from the cost of a tangible fixed asset. Students who have studied the provisions of the 1985 Companies Act in detail will know that companies have the option to capitalise general overhead costs when computing the cost of construction of a fixed asset. As is often the case with FRSs, FRS 15 narrows down the options available in the Companies Act.
The FRS gives a list of examples of directly attributable costs. Many of these are as you would expect, for example, the costs of site preparation and clearance. However one example that deserves slightly deeper study is:
" The estimated cost of dismantling and removing the asset and restoring the site, to the extent that it is recognised as a provision under FRS12, Provisions, Contingent Liabilities and Contingent Assets."
Such a provision is sometimes appropriate at the time the initial capitalisation of the asset occurs — it depends on whether the entity has a legal or constructive obligation to incur the expenditure at that time. In some cases the obligation does not arise until a later date, due perhaps to the effect of legislative changes or whatever. Therefore there may be occasions where such costs are capitalised from a date other than the initial capitalisation date. In accordance with the principles of FRS 12 the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.
Tutorial note
An article on FRS 12 (issued in September 1998) appeared in the March 1999 edition of the Student Accountant.
Similarly, abnormal costs, such as those relating to industrial disputes, are not directly attributable to bringing the asset into working condition and should not be capitalised. In this respect the provisions regarding the measurement of cost of tangible fixed assets are similar to those applied to the measurement of cost of manufactured stocks. The principles are not identical in every respect, though, because SSAP 9 requires that the `cost' of manufactured stock includes an appropriate proportion of fixed production overheads. FRS 15 only allows incremental costs to be capitalised.
Subject to what we said earlier regarding the possible subsequent capitalisation of removal and restoration costs, the FRS states that capitalisation of directly attributable costs should cease when substantially all the activities that are necessary to get the tangible fixed asset ready for use are complete. This is so even if the asset is not actually brought into use until a later date. Therefore as soon as an asset is capable of operating at normal levels it is ready for use. The fact that it may not in fact operate at normal levels immediately because demand has not yet built up does not justify further capitalisation of costs in the period when demand is building up.
The FRS is neutral on the capitalisation of finance costs incurred in respect of the construction of fixed assets. Capitalisation during the construction period is permitted rather than required. However, the entity must make a consistent choice and either capitalise whenever permitted under the FRS or not capitalise at all. In order to be consistent with the treatment of `other costs' only finance costs that would have been avoided if the asset had not been constructed are eligible for capitalisation. If the entity has borrowed funds specifically to finance the construction of an asset then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used.
If the carrying amount of a tangible fixed asset exceeds its recoverable amount then the fixed asset should be written down to the recoverable amount. The recoverable amount of a fixed asset is its value in use or, if higher, its net realisable value.
Subsequent expenditure undertaken on a tangible fixed asset should normally be written off to the profit and loss account. The only exceptions to this are where the expenditure:
Enhances the economic benefits of the asset in excess of the previously assessed standard of performance.
Replaces or restores a component of an asset that has been treated separately for depreciation purposes, for example the roof of a building.
Relates to a major inspection or overhaul that restores the economic benefits of an asset that have already been reflected in depreciation, for example the periodic overhaul of an aircraft.
Revaluation of fixed assets
The FRS allows, but does not require, entities to carry their fixed assets at revalued amounts. If the valuation route is chosen it should be applied consistently to all fixed assets of the same class (assets that have a similar nature or function within the business). Additionally the revaluations need to be regularly updated. This means a full valuation at least once every five years with a less detailed interim valuation in the third year and in other years if there is evidence that the value has changed significantly. As an alternative the valuations can be carried out on a rolling basis over a five-year cycle with an interim valuation on the remaining assets in the class where there has been indication of a material change in value. A key consequence of these provisions is that entities cannot `cherry-pick' the assets they carry at revalued amounts and they cannot allow `revaluations' to become too dated.
The FRS contains some reasonably detailed provisions regarding the exact meaning of the term `valuation'. As far as properties are concerned (these probably being the class of fixed asset most likely to be carried at valuation) the basic valuation principle is value for existing use — not reflecting any development potential. Notional directly attributable acquisition costs should also be included where material. However specialised properties may need to be valued on the basis of depreciated replacement cost, since there may be no data on which to base an `existing use' valuation. If properties are surplus to the entity's requirements then they should be valued at open market value net of expected directly attributable selling costs.
Revaluation gains are recognised in the statement of total recognised gains and losses unless they reverse revaluation losses on the same asset that were previously recognised in the profit and loss account. In these circumstances, the revaluation gain is recognised in the profit and loss account after adjusting for any reduction in depreciation caused by recognition of the original revaluation loss.
Example 1
A property was purchased on 1 January 1989 for £2 million. Annual depreciation of £50,000 was charged from 1989 to 1993 inclusive and on 1 January 1994 the carrying value of the property was £1,750,000. The property was revalued at £1.5 million on 1 January 1994 and a loss of £250,000 recognised in the profit and loss account. Following the revaluation the annual depreciation was reassessed at £42,000 and this amount was charged from 1994 to 1998 inclusive. On 1 January 1999, when the carrying value of the property was £1,290,000 the property was revalued again and the revalued amount was £1,800,000. The treatment of the revaluation surplus (of £1,800,000 - £1,290,000 = £510,000) is as follows:
£210,000 (£250,000 - 5 x {£50,000 - £42,000}) is credited to the PL account.
£300,000 (the balance) is credited to a revaluation reserve.
It is worth noting that, had the 1989 valuation not taken place, the carrying value of the property at 1 January 1999 would have been £1.5 million (£2 million - 10 x £50,000). Revaluing the property to the 1999 amount would therefore have generated a surplus of £300,000
Revaluation losses that are caused by a clear consumption of economic benefits, for example physical damage to an asset, should be recognised in the profit and loss account. Such losses are effectively akin to impairment losses and are therefore appropriately recognised in the profit and loss account as an operating cost similar to depreciation.
Other revaluation losses, for example the effect of a general fall in market values on a portfolio of properties, should be recognised in the statement of total recognised gains and losses. The effect of this treatment is to regard such losses as a valuation adjustment rather than an impairment. However if the loss is such that the carrying amount of the asset falls below depreciated historical cost, then any further losses need to be recognised in the profit and loss account.
Example 2
A property was purchased for £2.5 million on 1 January 1989. Annual depreciation of £60,000 was charged for 5 years from 1989 to 1993 inclusive. On 1 January 1994, when the carrying value of the property was £2.2 million, the property was revalued to £2.4 million. The appropriate annual depreciation was reassessed at £65,000 and this was charged from 1994 to 1998 inclusive. On 1 January 1999, when the carrying value of the property was £2,075,000, the property was revalued again and the revalued amount was £1.7 million on an existing use basis. The revaluation deficit was caused by a general fall in property prices rather than by a consumption of economic benefits.
It should be clear that the total revaluation deficit that is recognised in 1999 is £375,000 (£2,075,000 - £1,700,000). If the deficit had been attributable to a consumption of economic benefits then it would have been fully charged to the profit and loss account, regardless of any existing credit to the revaluation reserve in respect of that asset. However, given the fact that the deficit is due to a general fall in property prices then it is necessary to compute what the depreciated replacement cost would have been if the property had never been revalued. This would have been £1,900,000 (£2,500,000 - {10 x £60,000}). Therefore the revaluation deficit would be recognised as follows:
£175,000 in the statement of total recognised gains and losses — this being the amount by which the carrying value immediately before the second valuation exceeds the hypothetical carrying value had the property never been revalued in 1989.
£200,000 in the profit and loss account.
An exception to the above is where the recoverable amount of a property exceeds the revalued amount. This is perfectly possible since recoverable amount is often based on market value and market value can reflect development potential, which existing use value obviously cannot. To the extent by which the recoverable amount of the asset exceeds its revalued amount then the deduction from the profit and loss account is restricted.
Suppose, in the previous scenario, that the property had a market value of £1,750,000 on 1 January 1999. This means that the market value exceeds the revalued amount by £50,000. The revaluation deficit will now be dealt with as follows:
£225,000 (175,000 + £50,000) in the statement of total recognised gains and losses.
£150,000 (£200,000 - £50,000) in the profit and loss account.
The treatment of profits and losses on the sale of tangible fixed assets is unchanged from current practice. The exposure draft that preceded FRS 15 suggested that all fixed assets that were to be sold be revalued to market value immediately prior to sale. The practical effect of this measure would have been to report gains on disposal of fixed assets in the statement of total recognised gains and losses rather than in the profit and loss account. Responses to the exposure draft were extremely negative on this point and the Accounting Standards Board has therefore omitted it from the FRS. However it is worth noting at this point that the ASB may well have future plans to combine the profit and loss account and the statement of total recognised gains and losses into a single, albeit sectionalised, statement. Therefore the issue of reporting of gains or losses on sale of fixed assets may well be revisited.
Depreciation of tangible fixed assets
The FRS makes very few changes to the provisions of SSAP 12 as far as the measurement of depreciation is concerned. The FRS confirms that depreciation is an accrual technique. This is evident from the definition of depreciation that is given in the standard and reproduced below.
Depreciation is the measure of the cost or revalued amount of the economic beneifts of the tangible fixed asset that have been consumed during the period. Consumption includes the wearing out, using up or other reduction in the useful life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for the goods and services produced by the asset.
The FRS requires that depreciation should be recognised as an expense in the profit and loss account unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be the possible inclusion of depreciation in the costs incurred on a long term contract that are carried forward and matched against future income from the contract under the provisions of SSAP 9.
A key consequence of the concept of depreciation that is laid out in FRS 15 is that assets which are increasing in value still need to be depreciated. This has particular implications for the depreciation of fixed assets that have been revalued. Indeed after a revaluation the depreciable amount of a fixed asset normally increases so the depreciation charge is larger after revaluation than it was before! In the experience of the author this is a concept that some students find hard to understand. It is important to focus on the fact that the accountant's definition of depreciation is not framed in terms of loss in value of the asset but in terms of the consumption of economic benefits through use.
The FRS notes that a number of methods can be used in practice to allocate depreciation to specific accounting periods. Two of the more common methods are specifically mentioned:
The straight line method.
The reducing balance method.
Examples of these two methods are not provided in this article as it is assumed that you are familiar with them already. The FRS does not prescribe an appropriate method but notes that where the pattern of consumption of economic benefits is uncertain the straight line method is usually adopted. There may be occasions where a (partly depreciated) fixed asset is being depreciated according to a particular method and the directors consider that a different method would give a fairer representation of the consumption of economic benefits. In these circumstances the carrying value of the fixed asset is depreciated under the new method from the date of the change in method. This does not constitute a change in accounting policy.
The FRS states where a tangible fixed asset comprises two or more major components with substantially different economic lives each component should be accounted for separately for depreciation purposes and depreciated over its useful economic life. This has particular implications for the depreciation of properties. FRS 15 specifically states that land and buildings are separable components and should be dealt with separately for depreciation purposes. Freehold land does not normally require depreciation. The only exceptions would be land acquired for extractive purposes, for example a mine, where its usefulness ends following extraction of the minerals or whatever. Buildings on the other hand have a limited life and are therefore depreciated. The FRS states that an increase in the existing use value of the land on which a buiding stands does not affect the determination of the useful economic life or residual value of the building (and therefore the depreciation).
The issue of non-depreciation of properties is particularly relevant to entities that hold properties that are used for tourism or leisure purposes, such as hotels and restaurants. It has been the practice of some large companies (for example Trust House Forte) to charge no depreciation on properties such as hotels. The (slightly questionable) rationale for such a treatment is that the properties are maintained to such a high standard that the useful economic lives are infinite and therefore no depreciation is required. FRS 15 specifically states that subsequent expenditure on a tangible fixed asset that maintains or enhances the previously assessed standard of performance does not negate the need to charge depreciation. Clearly the anticipation that such expenditure is likely to be incurred will affect the original assessment of the useful economic life of the asset and so the annual depreciation charge. However this is different from saying that depreciation is not required at all.
At first sight it would appear that the issue of non-depreciation of properties has been settled by the requirements we have just discussed. However, FRS 15 seems to confuse the issue slightly by stating that fixed assets that are not depreciated because the amount of depreciation involved would be immaterial and be reviewed for impairment on an annual basis. (An annual impairment review is also required if the estimate of the useful economic life of a fixed asset is more than 50 years.) According to the FRS the amount of depreciation could be immaterial because:
the asset has a very long estimated future economic life;
the expected residual value of the asset, based on current prices, is very close to the carrying value.
At the end of the day, therefore FRS 15 does seem to leave open at least the possibility of non-depreciation of fixed assets other than land. It is too early to say whether practice in this area is likely to change significantly upon adoption of the provisions of FRS 15.
Before we leave the topic of non-depreciation of properties it is worth stating that FRS 15 does not address the issue of investment properties. Such properties continue to be dealt with under the provision of SSAP 19, although a future ASB project may well update the standard. Therefore the facility for companies to omit charging depreciation on investment properties providing they are revalued annually remains and is unaffected by FRS 15.
It is important to stress that the assessments of the useful economic life and residual value of a fixed asset are extremely subjective. The useful life and residual value will only be known for certain after the asset is sold or scrapped and this is clearly too late for the purpose of computing annual depreciation. Therefore, FRS 15 requires that the estimate of the useful economic life and (where material) the residual value should be reviewed at the end of each reporting period. In the case of the estimate of residual value this should be based on prices prevailing at the date of acquisition if carried at historical cost or at the date of the latest valuation if carried at revalued amount.
If either estimate changes significantly then that change should be accounted for over the remaining estimated useful economic life.
Example 3
An item of plant was acquired for £220,000 on 1 January 1999. The estimated useful life of the plant was 5 years and the estimated residual value £20,000. The asset is depreciated on a straight line basis. On 31 December 1999 the future estimate of the useful life of the plant was changed to 3 years, with a residual value, based on 1 January 1999 prices of £12,000.
At the date of purchase the plant's depreciable amount would have been £200,000 (£220,000 - £20,000). Therefore depreciation of £40,000 would have been charged in 1999 and the carrying value would have been £180,000 at the end of 1999. Given the reassessment of the useful economic life and residual value the depreciable amount at the end of 1999 is £168,000 (£180,000 - £12,000) over 3 years. Therefore the depreciation charges in 2000, 2001 and 2002 will be £56,000 (£168,000/3) unless there are future changes in estimates.
A change in the estimate of future economic life of a fixed asset may indicate an impairment if the estimate is shortened. In such circumstances the fixed asset would be written down to its recoverable amount and that amount, less any estimate of future residual value, written off over the remaining life.
Suppose, in the above example, that the recoverable amount of the plant at 31 December 1999 was estimated at £165,000. In these circumstances the plant would have suffered an impairment in value of £15,000 (£180,000 - £165,000). This amount would be written off to PL in the 1999 accounts. The depreciation in 2000, 2001 and 2002 would be £51,000 [(£165,000 - £12,000)/3].
Some types of business may hold a relatively large number of relatively low value fixed assets, for example tools such as screwdrivers and hammers etc. It is difficult to record each and every item individually in a fixed asset register and therefore difficult to provide depreciation. In such circumstances FRS 15 permits `renewals accounting' to be adopted. This effectively regards the whole quantum of individual assets as a single `infrastructure asset'. An estimate is made of the average annual expenditure that is necessary to maintain the `infrastructure asset' in its steady state. Actual expenditure incurred on the`infrastructure asset' is added to its cost and the average annual expenditure deducted from cost and charged to the PL as `depreciation'. On a medium term basis the carrying value of the `infrastructure asset' shouldn't change much since the expenditure actually incurred will approximate closely to the amounts deducted as `depreciation'.
`Renewals accounting' is permitted provided the following conditions are satisfied:
the infrastructure asset is a system or network that as a whole is intended to be maintained at a specified level of service potential by the continuing replacement and refurbishment of its components;
the level of annual expenditure required to maintain the operating capacity (or service capability) of the infrastructure asset is calculated from an asset management plan that is certified by a person who is appropriately qualified and independent;
the system or network is in a mature or steady state.
Closing Remarks
FRS 15 deals with three separate issues:
Determination of cost.
Revaluations.
Depreciation.
The key changes introduced by the FRS are in respect of revaluations. The FRS has issued some much needed regulation in this area and should lead to more comparable and useful financial statements. |
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