component approach towards property, plant and equipment, The

Accountancy SA,  Jan 2003  by Scheepers, Debbie

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ACCOUNTING

The International Accounting Standards Board's Exposure Draft of Proposed Improvements to International Accounting Standards (ED 155), issued in May 2002, proposes a number of changes to existing international accounting standards to remove alternative accounting methods, promote convergence and clarify accounting treatments.

Although it is not a completely new concept in the recognition of property, plant and equipment (PP&E), the component approach is extended in IAS 16 - Property, plant and equipment - to include the provision that subsequent expenditure should be added to the carrying amount of the asset when certain conditions are met and to distinguish between replacing or renewing a component. Currently, paragraph 12 of AC 123 allows for the application of a component approach in certain circumstances - the well known example of the airframe and engines of an aircraft that are to be treated as separate depreciable assets if they have different useful lives.

The purpose of this article is to critically discuss the implications of a component approach and the treatment of subsequent expenditure, proposed in IAS 16, which will affect AG 123 locally. Should the proposals of ED 155 be accepted, they will become operative for annual financial statements covering periods on or after 1 January 2003.

WHAT IS MEANT BY A COMPONENT APPROACH I

According to paragraph 12 of IAS 16 (proposed revision), an entity allocates the amount initially recognised in respect of an asset to its component parts and accounts for each component separately when:

* The components have different useful lives, or

* The components provide benefits to the entity in a different pattern.

In these circumstances it is necessary to use different depreciation rates and methods.

The exception now becomes the rule in the amended paragraph 12, which clearly states that a component approach to depreciation and to the treatment of expenditure on replacing or renewing a component of an item of PP&E is applied to all such items and is not merely applied in certain circumstances. Under a component approach, each material component of an asset with a different useful life or different pattern of depreciation is accounted for and depreciated separately. Expenditure on replacing or renewing any component is capitalised and the carrying amount of the replaced or renewed component is written off.

HOW DO THE RECOGNITION REQUIREMENTS FOR PP&E AFFECT THE COMPONENT APPROACH? I According to paragraph 7 of IAS 16 (proposed revision), an item of PP&E shall be recognised as an asset when, and only when:

* It is probable that future economic benefits associated with the asset will flow to the entity, and

* The cost of the asset or, when the asset is carried at a revalued amount, the fair value of the asset, can be measured reliably.

Before an item of PP&E can be recognised as an asset it must comply with the above. Once an item of PP&E is recognised as an asset, the entity allocates the amount recognised to the component parts of the asset and accounts for each component separately.

REPLACING OR RENEWING A COMPONENT I Paragraph 22A of IAS 16 (proposed revision) states that expenditure incurred in replacing or renewing a component shall be accounted for as the acquisition of a separate asset and the carrying amount of the replaced or renewed component asset shall be written off.

The cost of a major inspection of an item of PP&E, to allow the continued use of the asset, may be a separate component of the cost of that item and will have to be allocated as such on initial recognition. In these circumstances, when each major inspection is performed, its cost is capitalised as a replacement component, and any remaining carrying amount of the replaced component is written off. This implies the incorporation of SIC 23 (AC 423) into the proposed revision of IAS 16.

SUBSEQUENT EXPENDITURE I Paragraph 23 of IAS 16 (proposed revision) states that subsequent expenditure relating to an item of PP&E that has been recognised shall be added to the carrying amount of the asset when and only when:

* It is probable that the expenditure will increase the future economic benefits embodied in the asset in excess of its standard of performance assessed immediately before the expenditure was made.

All subsequent expenditure that fails the criteria for capitalisation shall be recognised as an expense in the period in which it is incurred (IAS 16 (proposed revision): par 23A).

IMPLICATIONS OF THE TREATMENT OF SUBSEQUENT EXPENDITURE I

The application of the principle established in paragraph 23 of IAS 16 (proposed revision) will have a profound influence on the accounting treatment of PP&E, as we knew it.

Previously expenses were capitalised when it was probable that future economic benefits in excess of the originally assessed standard of performance would flow to the enterprise. IAS 16 (proposed revision) implies that an assessment is made immediately before the expense is incurred. Should the expense increase the future economic benefits embodied in the asset, in excess of its standard of performance immediately before the expenditure was made, the expense is to be capitalised.