From the IFRS Institute - November 2017
Large property, plant and equipment items often comprise multiple parts with varying useful lives or consumption patterns. Unlike US GAAP, IFRS requires companies to separately depreciate those parts that are significant. While the objective is conceptually simple, implementing the component approach can be challenging.
Complex assets, such as airplanes, ships, buildings, large manufacturing equipment and utilities infrastructure, often comprise multiple parts that need to be periodically replaced or overhauled during their useful lives.
IFRS1 requires significant parts of PP&E items with differing depreciation methods or lives to be depreciated separately. Further, upon replacement or overhaul of a part, the company is required to capitalize the cost and derecognize the carrying amount of the replaced part.
The objective of the component approach is to more precisely reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the company.
Under US GAAP, the component approach is permitted, but not required. In practice, few companies apply it. However, the option may prove useful for dual reporters that seek to avoid maintaining two fixed assets ledgers. When the component approach is not used, in our experience, PP&E items are usually depreciated by determining a useful life for the item as a whole.
Step 1: Identify the significant components of a PP&E item
To apply the component approach, it is necessary to identify the significant parts of an asset. IAS 16 specifies two different types of components: (1) a physical component and (2) a non-physical component that represents a major inspection or overhaul.
Component accounting for inspection or overhaul costs is intended to be used only for major expenditures that occur at regular intervals over the life of an asset and last more than one period; this is referred to as ‘planned major maintenance’ under US GAAP. Costs associated with routine repairs and maintenance are expensed as incurred.
Step 2: Determine the cost of the components
Each component is measured at cost at initial recognition, which can create many practical issues. Assets are usually purchased for a single sum without knowing the cost of the individual components.
In our view, the cost of the individual components should be estimated either with reference to current market prices (if possible), in consultation with the seller or contractor, or using some other reasonable method of approximation (e.g. relative values).
Other complexities arise in determining the implicit cost of a major inspection or overhaul, and in allocating the total costs to the different components when the underlying asset comprises a number of physical and non-physical components (e.g. major inspection or overhaul).
Step 3: Depreciate each component separately
The components identified in Step 1 are depreciated separately over their respective useful lives in a manner consistent with their pattern of consumption. However, regardless of the components identified for an underlying asset, on the balance sheet the respective carrying amounts are all presented within the single line item, PP&E.
Step 4: Replace the components
The remaining carrying amount of a component that is replaced by a new component is derecognized. However, any amount written off is included in depreciation instead of being classified as a loss on disposal. We believe the extra depreciation is in effect a revision of the estimated useful life of the component. Costs associated with replacing items not identified as a component are expensed as incurred.
ShipCo runs a merchant shipping business and has just acquired a new ship for $400 with a useful life of 15 years.
The ship will be dry-docked every three years for the major overhaul to be carried out. At the date of acquisition, the dry-docking costs for similar ships that are three years old are approximately $80. Therefore, the cost of the dry-docking component for accounting purposes is $80 and this amount will be depreciated over the three years to the next dry-docking.
ShipCo’s ship comprises two physical components: the ship’s body of $250 and the engines of $150. The dry-docking will involve servicing both of these components. In practice, the ship would comprise a number of other insignificant parts that may be grouped together to be depreciated over a useful life that faithfully represents the depreciation profile of its parts; however, the example has been simplified for illustrative purposes.
ShipCo concludes that it will allocate the cost of the dry-docking component between the ship’s body and the engines on the basis of their relative carrying amounts. On this basis, the allocation of the $400 purchase price to the three components of the ship would be as follows.
|Ship’s body||250 - (250/400 × 80) = $200|
|Engines||150 - (150/400 × 80) = $120|
Identifying each component and the required data, such as the date purchased and the original cost, can be challenging. This will particularly be true for companies engaging in capital intensive businesses and transitioning to IFRS. The detailed recordkeeping needed to apply the component approach may not have been required under the company’s current GAAP.
Companies may look to operational or tax data to retrieve sufficient information for each component. A typical challenge when looking to data outside of the accounting department is verifying the completeness and accuracy of system-generated reports or other types of schedules that are being relied on. Changes to fixed assets ledgers and CAPEX procedures may also be required.
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.