Property, Plant and Equipment – Changes under Ind AS

Currently, under Indian GAAP, accounting for PPE is covered by AS 10 ‘Accounting for Fixed Assets’. The other standards and regulations which are applicable to the accounting for PPE include AS 6 ‘Depreciation Accounting’ AS 16 ‘Borrowing Costs’, AS 11- The Effects of Changes in Foreign Exchange Rates and certain notifications of the Ministry of Corporate Affairs (MCA).

Under Ind AS, the accounting for PPE is covered by Ind AS 16 – ‘Property, Plant and Equipment’ along with guidance under Ind AS 23 – ‘Borrowing Costs’, and Ind AS 21 – ‘The Effects of Changes in Foreign Exchange Rates.

In this article, we will examine and illustrate some of the key differences in practice between Ind AS and Indian GAAP, as it is currently applicable, with respect to the accounting of PPE.

• General and Administrative Overheads:

Under the current Indian GAAP, certain general and administrative expenses which are specifically attributable to the cost of the asset or construction of a project are capitalised as part of the cost of the asset. These expenses are generally in the nature of start-up costs or pre-operating expenses.

As per Ind AS 16, costs eligible for capitalisation are the cost of the asset, duties and non refundable purchase taxes, less trade discounts and rebates. It includes those costs which are directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in a manner intended by management. This capitalised cost of the asset does not include general and administrative overheads.

• Foreign Exchange Differences:

As per the revised AS–11 and subsequent MCA notifications, foreign exchange differences on foreign currency long term monetary items related to acquisition of a depreciable capital asset may be capitalised to the cost of the asset and depreciated over the balance life of the asset. This is an irrevocable option which the entities have, currently under the modified AS 11.

Under Ind AS, there is no such guidance and all foreign exchange differences on acquisition of assets are expensed to the income statement. Capitalisation is not permitted. Thus, there would be a difference in the capitalised value of the property, plant and equipment under Ind AS with a corresponding impact to the depreciation amount in the income statement.

• Asset Retirement Obligations:

At present, there is a divergence in practice under Indian GAAP such that certain companies do not upfront recognise the cost of dismantling or removing the asset or restoring the site on which the asset was located to its original condition. Such obligations are recorded in the financial statements, only when the liability is incurred.

Ind AS 16 provides that the cost of the asset also includes the initial estimate of the costs of dismantling and removing the item, and restoring the site to its original condition. Hence, the cost of the asset should include an amount equivalent to the present value of the liability recognised for the cost of dismantling or removing the asset and of restoring the asset to its original condition as per initial estimates of the management. Interest, which is imputed in the transaction, shall be recognised subsequently through the profit and loss account. The total cost of the asset (original cost plus the present value of the obligation) shall be depreciated as per the useful life estimated by the management.

Let us understand this concept through the following example:

Example 1:

Company A is a chemical manufacturing company, which has recently installed an asset at its manufacturing facility. The cost of the asset is Rs. 100 lakh and the Company is expected to incur certain restoration costs on the land on which the asset is located at the end of five years. The Company follows the straight line method of depreciation. The Company estimates that the restoration costs shall be Rs. 20 lakh. The current market rate of interest is 10%. Hence, the Company estimates that the present value of the obligation on day one at an interest rate of 10% shall be Rs. 12.42 lakh (approx).

– Initial measurement

As per the provisions of Ind AS 16, the Company will capitalise the asset at a value of Rs. 112.42 lakh (Rs. 100 lakh of its initial capitalised value of the asset and Rs. 12.42 lakh of its estimate of restoration costs). It will also record a provision of Rs. 12.42 lakh towards this liability. The accounting entry will be as shown in Table 1.

Table 1 – Initial Measurement Entries (Rs. in lakh)

– Subsequent measurement

The company follows a straight line method of depreciation and hence, would recognize the depreciation expense as shown in Table 2.

Table 2 – Deprication (Rs. in lakh)

The provision has been recognised at its present value of Rs. 12.42 lakh. However, payment to be made at the end of the year 5 is Rs. 20 lakh. Accordingly, at the discount rate of 10% determined earlier, the provision shall be accreted through the income statement to Rs. 20 lakh at the end of the fifth year. For detailed calculation of the accretion amounts, please refer to the Table 3:

Table 3 – Accretion to Provision for Restoration Cost (Rs. in lakh)

Accounting entry:

*Every year

Income statement a/c (imputed interest) Dr.

To Provision for restoration costs Cr.

At the end of year 5

Provision for restoration costs a/c Dr. (Rs. 20 lakh)

To Cash/Bank a/c Cr. (Rs. 20 lakh)

Deferred Payment Terms:

Under Indian GAAP, the capitalised cost of the PPE is the transaction value – the value agreed to be paid for the cost of the asset. Hence, deferred payment terms do not affect the capitalised value of the asset.

The accounting practice prescribed under Ind AS 16 differs from Indian GAAP. It defines that the cost of acquisition of the asset is equal to its cash price or cash equivalents paid or the fair value of other consideration given to acquire the asset. Thus, in a scenario where the terms of acquisition, payment is deferred over a period of time, the asset would have to be recognised initially at its present value. This would also apply where companies retain retention money for a particular asset. This has been further explained through the example given below:

Example 2:

Company C purchases an asset at a cost of Rs. 66 lakh with a useful life of six years. The normal trade practice in the industry is for the purchaser to retain a certain amount of the cost of the asset which is payable two years from the date of purchase. Accordingly, Company C agrees to pay Rs. 60 lakh and to hold Rs. 6 lakh as retention money payable after two years from the date of purchase.

The market rate of interest on the date of the transaction is 9%. Accordingly, the present value of the retention money discounted at 9% for two years amounts to Rs. 5,05,008. The accounting entries in the books of Company C are as shown in Table 4:

Table 4 – Accounting for Retention Money in Asset Purchase

Depreciation shall be computed and accounted for on the capitalised value of the asset Rs. 6,505,008 over the estimated useful life of the asset – 6 years.

Borrowing Costs:

Differences in practice with respect to borrowing cost capitalisation between Indian GAAP and Ind AS include:

•    Guidance under Indian GAAP and Ind AS state that ‘Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset.’ Hence, to qualify for capitalisation of borrowing costs, the asset should take a ‘substantial period of time’ to get ready for its intended use or sale. While the definitions of a qualifying asset are predominantly the same, there is a bright line of 12 months given under Indian GAAP for ‘substantial period of time’, whereas under Ind AS there is no bright line given. An assessment of substantial period of time is based on management’s best estimate. Thus, the borrowing costs qualifying for capitalisation may differ under Indian GAAP and Ind AS.

•    Secondly, capitalisation of borrowing costs under Indian GAAP is based on the contractual rate of interest of loans borrowed. However, under Ind AS, such capitalisation is based on the effective interest rate of loans borrowed. An effective interest rate is computed after taking into consideration amortisation of loan processing fees and other upfront charges on availing the loan facility.

Depreciation:

Under Indian GAAP currently, a company may choose to depreciate its assets in the financial statements, using only the written down value or straight line method. The rates for such depreciation are governed by Schedule XIV to the Companies Act, 1956 and as a practice, most companies adopt the rates of depreciation prescribed in the Schedule.

Ind AS requires a company to follow that method of depreciation that best reflects the pattern in which, the future economic benefits are expected to be consumed by the company. Depreciation as per this method is based on the useful life of the asset which is an estimate by the management, which may be different from the rates entities use as per Schedule XIV at present. The residual value and the useful life of an asset, need to be reviewed at least at each financial year-end, and if expectations differ from previous estimates, the changes are to be accounted for as a change in an accounting estimate. Further, a change in the depreciation method shall also be treated as a change in accounting estimate and effected prospectively.

There may be certain components of an asset which are significant and have different useful lives. Ind AS requires a company to depreciate these components, separately based on an estimate of their useful lives. Such components include major inspection costs or overhaul charges. This approach towards measurement of depreciation, amortises the cost of replacement of key components during overhauls in a systematic manner.

Example 3

AJ Engineering Limited purchases an asset for its manufacturing activities. The total cost of the asset is Rs. 100 lakh and its useful life is six years. The asset has three main components – Component A with a cost of Rs. 60 lakh and a useful life of six years, Component B with a cost of Rs. 30 lakh and a useful life of three years and Component C with a cost of Rs. 10 lakh and a useful life of two years. The management believes that the straight line method of depreciation, most appropriately reflects the pattern in which future economic benefits shall flow to the company. Components B and C are replaced when their useful life has been exhausted.

The capitalised cost of the asset is Rs. 100 lakh. In the second year and third year, components C and B will be derecognised respectively, and replaced by fresh components and depreciated over their estimated useful lives i.e. two and three years. The measurement of depreciation shall be as shown in Table 5:

Table
5 – Depreciation under Component Approach (Rs in lakh)

Upon de-recognition and recognition of components, the accounting entries as shown in Table 6 shall be passed:

Table 6 – Accounting Entries on De-recognition (Rs. in lakh)

Similar entries will need to be considered for Component C.

Example 4

Company P runs a merchant shipping business and has just acquired a new ship for Rs. 40 lakh. The useful life of the ship is 15 years, but it will be dry-docked every three years and a major overhaul shall be carried out. At the acquisition date, the dry-docking costs for similar ships that are three years old, is approximately Rs. 8 lakh.

Hence, while capitalising the ship in the books, the dry-docking costs shall be considered as a separate component, with a useful life of three years and amounting to Rs. 8 lakh. The bal-ance amount, shall be capitalised to the value of the ship – Rs. 32 lakh (assuming there are no other components).

Thus, at the end of the third year, Rs. 8 lakh shall be fully depreciated and the company will incur dry docking costs as anticipated. Accounting for this is done as shown in Table 7 and Table 8:

Table
7 – Accounting for ship and depreciation thereon (Rs. in lakh)

Conclusion:

The principles of accounting for PPE under Ind AS as discussed in this article, vary in a number of aspects vis-à-vis Indian GAAP. The application of these principles shall require training and educating the employees as well as aligning reporting systems and internal controls to enable the entity to report their property, plant and equipment amounts appropriately and accurately.