Spare parts, residual value and depreciation in the context of fixed assets – IAS 16

Julia GŁOWSKA
Audit Assistant at RSM Poland

Each of us an owner

Each economic entity has at least one component of a tangible fixed asset – a mobile phone, a car, or real estate. In this case, size does not matter. Since it is such a common item on the balance sheet, tangible fixed assets require a separate standard, which accurately regulates the manner of their recording in the financial statements so that users of the annual report can easily become aware of the investments of the individual in tangible fixed assets. One such standard is International Accounting Standard 16 (hereinafter: IAS 16)[1],according to which most listed companies that are public interest entities (PIE) must report.

Tangible fixed assets (hereinafter: TFA) are fixed assets used over one balance sheet period, which the enterprise possesses for production, service or administrative purposes. IAS 16 also includes fixed asset component such as: production plants that are used in agricultural activities. Earlier, this atypical fixed asset was included in IAS 41 on biological assets. An example of a production plant is an orchard fruit tree, which is grown with the expectation that it will provide agricultural products in the long run, and the likelihood of selling the tree as an agricultural product is low.

Subsequent expenditure

A fixed asset often requires a large amount of expenditures to be incurred in order to adapt it to use for production or administrative purposes. At the moment of entry into the books of records, the fixed asset is valued at the purchase price or production cost. And what about the subsequent expenditure incurred on the tangible fixed assets? Costs related to the ongoing maintenance of such fixed assets are recognized in the financial result. We can increase the initial value of such fixed assets by incurring improvement costs. According to IAS 16, improvement is when we can reliably estimate expenditures and when future economic benefits, such as extending the life of a fixed asset, outweigh the current benefits without incurring these expenditures.

Let us present a situation in which we determine whether something should be an activated cost on a given fixed asset:

A production company uses a machine that is serviced every year, and the cost of such service is PLN 25,000. During this years’ service, the company decided to replace a machine component to improve the efficiency of the production line. Thanks to the new part, the machine produces more products in one hour[2]. In the example described, the company should consider service costs as the costs of current maintenance of the machine, i.e. refer it to the profit and loss account and activate the cost of the machine's spare part, thus increasing the initial value of the fixed asset. It is worth emphasizing that fixed assets are often made up of components (e.g. an engine in a machine) that are replaced or exchanged at regular or less frequent intervals. The cost of such a part should also be recognized as the carrying value of the fixed asset and should be properly depreciated according to its individual depreciation rate.

Life of a fixed asset

Fixed asset depreciation is an important tax and accounting issue. IAS 16 defines the two most important aspects of this process. First, the remission of the asset is to be carried out in a systematic manner throughout the exploitation period of a given component of fixed assets. Secondly, depreciation methods should be reviewed at least once at the end of each year.

Returning to the example above; what if we assume a production period of 25 years for the production machine, although we know that the engine, i.e. an important component of this fixed asset, will wear out sooner and be replaced? According to IAS 16, such machine components can be depreciated separately, i.e. for a machine we can apply a 4% depreciation rate, and for an engine - 15%.

Depreciation charges are recognized in the profit and loss account or included in the carrying value of another asset item. For example, we are talking about inventories, which are current assets produced with the help of tangible fixed assets. In the discussed IAS there is also a reference to IAS 2, which is responsible for presenting the method of valuation and presenting inventories. For example, depreciation of machinery and equipment used for the production of a product of a given enterprise is referred to the value of production in progress, and then recognized as the cost of the finished product sold. It is also possible that the depreciation of given device X will increase the initial value of another fixed asset that is generated using X.

What about the value at which depreciation should be made? This is the initial value of the fixed asset measured at purchase price or production cost, less the residual value. The residual value is the value of the asset, which we expect to receive after the period of its use; this is often the net sale price we get after selling the asset component. Referring to the example: the company purchased a technical device at a price of PLN 25,000 and estimated that after a period of use it will be sold for the amount of PLN 5,000 (the amount of disposal minus all transaction costs). The residual value, from which we make of depreciation is PLN 20,000.

Linear and then natural method?

The standard is periodic verification of both the residual value and the useful life of a given asset (IAS 16, para. 50 et seq.). It is important to take all the information flowing from outside and inside the organization that may indicate the need to change either the residual value or the useful life of the assets into account. What about depreciation methods? IAS 16 - in contrast to the Accounting Act - allows, and even suggests, changing the methods of amortization of fixed assets. In cases where the expectations regarding the use of a given TFA component have changed, and consequently the expectations regarding future economic benefits changed as well, a change in the depreciation method should be considered (IAS 16, par. 61 et seq.). At some point in the life of a fixed asset, it may be necessary to change the linear method to e.g. natural, i.e. based on the number of products manufactured.

The world is shrinking, companies are becoming global, and rules, in particular regarding reporting, are becoming international. Each of the people who deals with accounting notes that we are aiming to harmonize national accounting rules with international standards. Therefore, it is worth being up to date with them, in particular with regard to IAS 16 on fixed assets and the new IFRS 16 standard on leasing, especially since each organization owns or uses tangible assets.