It is said that a balance sheet is a snapshot of a company’s financial health. However, the snapshot becomes immaterial if meaningful information cannot be drawn from it. To maintain the fair representation of all information, many companies and enterprises use classified balance sheets. Classification of assets plays a pivotal role for a business when external stakeholders are a user of information.
By classifying the assets based on existence, usage, and conversion in cash, it is easy to calculate different ratios. Investors can make informed decisions if a company uses a classified balance sheet. Understanding every type of asset help determining its contribution to the firm’s cash flow and revenue generation.
Property, Plant & Equipment is a category of long-term assets. Under PP&E, machinery, plant, furniture, land, building, and office equipment are recorded. Machinery and plant are treated as long-term operating assets generally. However, if the company’s business is selling machinery, the purchase of machinery will be recorded as inventory instead of an asset. In this article, we will talk about the classification and recognition of machinery in the balance sheet.
What Is Machinery In Balance Sheet?
Machinery can be defined as,
Machinery and plant is a set of major tools and equipment used to produce products and services and help in the operation of a business. It is a tangible, long-term, operating asset that is depreciated over its useful life. When a company purchases machinery, it is recorded as capital expenditure in books of accounts.
Machinery is defined under the IAS 16 of International Accounting Standards. Any machinery is recorded under the head of fixed assets if its economic benefit is extended for more than 12 months. Besides, there is a condition of materiality and reliable valuation to treat machinery as part of fixed assets.
The examples of machinery vary from industry to industry. Bulldozers, cranes, cement makers, etc., are machinery for a construction company. Similarly, the machinery of a textile company will be thread machines, dying machines, yarn gassing machines, printing machines, spinning machines, etc.
Let’s see the recognition of machinery in the balance sheet.
Recognition Of Machinery
IAS 16 governs the recognition, measurement, and calculation of plant, property, and equipment. Therefore, the recognition of machinery is also made according to standards for fixed assets under International Accounting Standards.
Following criteria must be fulfilled to record any machine or plant as a long-term asset of the business:
- It is expected that a machine purchased will give economic benefit to the business for more than 1 year or one operating cycle.
- It is easy to calculate the fair value of a machine with reliability and consistency.
The recognition principle applies to all kind of plant, machinery, and property except following:
- Any machinery that is held for sale under the IFRS 5 signifying the assets held for sale and discontinued operations
- Agriculture-related biological assets are also not included in the machinery account on a balance sheet.
- Mineral rights and mineral reserves.
Any of these assets is not recorded as a fixed asset. However, the machinery & equipment used for maintenance and operations of the assets mentioned above will be recognized as the long-term PP&E.
Measurement Of Machinery
The measurement and calculation of machinery are also governed under the IAS 16. Machinery is recorded as a long-term asset at the time of purchase, and it includes any additional costs incurred for installation and transportation. The cost of machinery is measured as initial measurement and subsequent measurement(measurement after recognition).
Initial Recognition(Cost Measurement)
The cost of machinery is governed under IAS 16.15. According to the standards, the measurement of machinery cost should be done in the following way:
- The cost of a machine is its purchase price at the time of acquisition. It also includes the installation costs, costs incurred to make a machine operational, transportation, and carrying costs of the asset. Sometimes, a machine is acquired, but payment has been deferred. The difference between the purchase price and the total amount paid is recognized as the interest rate. It is also included in the cost.
Under IAS 16.24, machinery might be acquired by exchanging one or more items. How is the cost recognized in the exchange transaction?
The cost of machinery is determined as its fair market value. There might be instances when fair value is not used to determine the initial cost of machinery acquired by exchanging other equipment or machine. The following conditions apply when fair value is not used:
- The exchange transaction does not include commercial substance. The commercial substance can be explained as the involvement of any monetary gains resulting from the exchange. An exchange transaction is said to have commercial substance if:
- The cashflow timing, risk, and amount of received machinery is different from that of the transferred machinery
- If the business operations where the transferred or received machinery belongs is affected by the exchange transaction
- The fair value of received and transferred machinery cannot be calculated with reliability.
It must be noted that the cost of machinery does not include the cost of removing previous machinery or disposal of old machinery. It will be recorded as capital gain or loss on the old machine.
Once the machinery has been recognized as part of business assets, the accounting department can record the value of the machine. It can be recorded under the cost model or revaluation model. However, consistency is essential for the whole class of PP&E. for instance, if you have used the cost model for machinery, it is necessary to apply the cost model on furniture.
The Cost model implies that the machinery will be recorded at the historical value of purchase. The accumulated depreciation for all the previous years will be deducted to record the net book value of the machine. Any loss of the machine’s value due to a fault or deterioration will be deducted from its historical cost.
Under the revaluation model, the machine must be revalued regularly. Under IAS 16.31, the subsequent depreciation(depreciation for the last accounting cycle) and any impairments are deducted from the fair value of the machine to find revalued amount. However, the condition of reliable calculation of fair value also applies in the revaluation model.
The revaluation model is used to eliminate any disparity between a machine’s fair value and its balance sheet value. When machinery is revaluated, there are chances that fair value might be higher than book value. In that case, the surplus fair value has to be credited into comprehensive income as a revaluation surplus.
The decrease in fair value should be treated as an expense. The amount of expense recognized should be only the excess amount from any surplus in previous accounting cycles. For instance, if a machine had a revaluation surplus of $800 in year 1. When the year 2 revaluation was performed, there is a decline in fair value by $1000. In this case, only $200 will be realized as an expense. $800 will be set off with a revaluation surplus.
How to calculate the depreciation on machinery?
Depreciation is defined under IAS 16.51 as the systematic allocation of an asset’s value over its useful life. To calculate depreciation on machinery, a company can use a straight-line depreciation or declining balance method. The straight-line method implies that the cost of machinery with less residual value is divided into equal amounts. Each year, the amount is deducted from the value of the asset.
The Declining Balance Method is generally based on percentages. More depreciation is allocated to book value in the first few years of usage in the declining balance method than in the later years.
Following considerations must be recognized when calculating the depreciation of machinery:
- The residual or salvage value of machinery and its useful life must be re-evaluated every year. If any difference in estimates is found, changes should be made in estimates.
- A business entity must review the depreciation methods at least once a year.
- The depreciation of machinery must be charged to the profit and loss account.
- Depreciation of machinery should be recognized from the time when it is made operational.
Under IAS 16.53, an enterprise is bound to disclose the following information about its machinery, plant, and other equipment:
- How carrying amount is measured(the basis for measurement)
- Which depreciation method is used
- Useful life, disposal value, and rates of depreciation
- The gross carrying amount of machinery, its accumulated depreciation, or any damages
- Reconciling carrying value at the beginning and closing dates of a year. The reconciliation has to be done for any depreciation, addition of new machinery, disposal of old machinery, revaluation, etc.
Machinery is a vital resource and asset for a business’s operations. Besides, it is part of the asset class having great importance for investors and stakeholders. Since machinery is a company’s capital investment, it will be a positive signal for investors if a company is investing in machinery.