In accounting, there are several areas where management’s estimates are involved. Accounting of property, plant and equipment (PPE) also involves areas where management’s estimation is required. We’ll discuss these areas in this chapter.
An item of PPE is expected to generate economic benefits in future for at least more than a year. Useful life of an asset refers to the number of years for which that asset is expected to generate economic benefits. Determining useful life of an item of PPE requires management’s estimate, which should be reasonable and consistent with the management’s experiences and industry norms for similar assets. Useful life is then used to calculate depreciation of PPE.
Management should review its useful lives estimates of PPE at the end of each reporting period. If new information suggests that useful life needs to be revised, it is accounted for prospectively i.e. carrying amount of PPE at the date of revision is depreciated over its remaining useful life. No adjustment is made to prior years’ numbers.
Depreciable amount and salvage value
Depreciable amount is the difference between cost and salvage value. Depreciable amount of an item of PPE is depreciated over its useful life.
Depreciable amount = Cost* – Residual Value
* If revaluation model is being followed, then it will be cost or revalued amount instead of cost in the above formula.
Salvage value or residual value is the value of an item of PPE that an entity expects to fetch at the end of its useful life. With the passage of time and with the usage of an item of PPE over its useful life, it tends to lose value because of normal wear and tear. However, it does not necessarily mean that the asset’s value will be zero at the end of its useful life. Quite often, they are sold or scrapped for some consideration. This value at the end of its useful is called salvage value, and determining it requires management’s estimation.
Management should review its salvage value estimates of PPE at the end of each reporting period. If new information suggests that salvage value needs to be revised, it is accounted for prospectively i.e. revised depreciable amount of PPE at the date of revision is depreciated over its remaining useful life. No adjustment is made to prior years’ numbers.
During impairment testing, recoverable amount of PPE is required to be calculated which is the higher of the following:
- Net realizable value i.e. fair value less cost to sell
- Value in use
Determining fair value of PPE for calculation of net realizable value often involves significant assumptions and management’s estimates. Similarly, determining value in use involves estimating future cash flows associated with the asset and discounting them to calculate present value of estimated future cash flows. In all these areas where management’s estimates are required, management of the business should be objective and make unbiased estimates which are reasonable and justifiable.