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Fixed asset toolkit: What can I capitalize? · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:06
  SPEAKER_01: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_01: I'm Heather Horn.
• 0:11
  SPEAKER_01: Thanks for tuning in to another episode in our Toolkit series, where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:26
  SPEAKER_01: This month we're all about fixed assets.
• 0:52
  SPEAKER_02: And the thought behind that is that whether the company capitalizes and depreciates the costs or just expenses the costs as they're incurred, it wouldn't be material to the financial statements.
• 1:06
  SPEAKER_02: But that just means it's really just being done for administrative convenience.
• 1:12
  SPEAKER_02: It's not really an accounting policy.
• 1:15
  SPEAKER_02: But a lot of companies, a lot of people might think that it is and ask questions about, well, we used to only capitalize amounts about this amount of money, and then we want to change that.
• 1:26
  SPEAKER_01: That was my guest, Jay Sulliver, a partner in our national office.
• 1:31
  SPEAKER_01: Jay's here to cover some of the challenging questions that arise in the process of capitalizing fixed asset costs.
• 1:38
  SPEAKER_01: We're talking about things like asset acquisitions, construction costs, and how to account for interest expense on projects you're building.
• 1:46
  SPEAKER_01: There's a lot to cover, so let's get started.
• 1:54
  SPEAKER_01: Jay, welcome back to the podcast.
• 1:56
  SPEAKER_01: As always, so nice to have you on and thanks showing your versatility.
• 2:00
  SPEAKER_01: You were last year about compensation.
• 2:02
  SPEAKER_01: And this month you're on to help us talk about some fixed asset matters.
• 2:07
  SPEAKER_01: In the first episode in the series, Beth was on talking about distinguishing between asset acquisitions and business combinations when you're buying a group of assets.
• 2:16
  SPEAKER_01: But I know a lot of questions, we're getting a lot of questions on all different types of fixed assets.
• 2:21
  SPEAKER_01: And actually, the genesis for this series was that our PPE guide is one of our most popular guides, which I think was a little surprise to us.
• 2:31
  SPEAKER_01: So with all of the background then, Jay, I think what might be helpful is just sort of level set some of how we're thinking about this and maybe a little preview of what we're covering today.
• 2:42
  SPEAKER_02: Sure.
• 2:42
  SPEAKER_02: Well, thanks for having me, Heather.
• 2:44
  SPEAKER_02: It's always great to be here to talk with you about many different topics.
• 2:48
  SPEAKER_01: Exactly.
• 2:49
  SPEAKER_02: Um I would say the accounting guidance about fixed assets says that property, plant, and equipment is what it calls the section for this.
• 2:58
  SPEAKER_02: And I'll call that PPE throughout the podcast.
• 3:02
  SPEAKER_02: That is initially reported at its historical cost, and then that's adjusted over time for depreciation and when necessary, impairment.
• 3:13
  SPEAKER_02: And the guidance does go on to say, and I'll basically quote it here, that the historical cost of acquiring an asset includes the costs necessary to get it into the condition and location necessary for its intended use.
• 3:31
  SPEAKER_02: But then that's about it.
• 3:32
  SPEAKER_02: There's a fair bit of guidance around impairments and disposals, which we'll talk about in some other episodes this month, and capitalized interest, which I'll talk about a little later, but there really isn't a lot of other specifics on exactly what costs to include or exclude in the fixed assets.
• 3:49
  SPEAKER_02: Outside of the real estate development industry, which isn't what we're trying to cover in today's podcast, I'm talking here about other kinds of commercial companies that use fixed assets in their operations.
• 4:04
  SPEAKER_02: So what we often look to for interpretive help here is a proposed statement of position or SOP that the predecessor of the Financial Reporting Executive Committee, or FINREC, put out back in 2003.
• 4:20
  SPEAKER_02: And although this was never approved as a final document and therefore it isn't authoritative, the proposed SOP did contain some thoughts about capitalizing costs for PPE assets that are helpful when considering the accounting treatment here.
• 4:38
  SPEAKER_01: All right, so Jay, frequent listeners to the podcast know that I have a background in the power and utilities industry.
• 4:45
  SPEAKER_01: And I think one of the most frequent items we would talk to clients about, and I would talk to my team about is just how to think about what you're going to capitalize.
• 4:54
  SPEAKER_01: And I know that issue is not unique to power and utilities.
• 4:57
  SPEAKER_01: So when you get that question, how do you start thinking about that?
• 5:02
  SPEAKER_02: Well, you're right.
• 5:04
  SPEAKER_02: You know, I said before, you're supposed to include the costs that are necessary to get the asset into the condition and location necessary for its intended use, but we do need a structured way to think about that.
• 5:17
  SPEAKER_02: So that unissued SOP I mentioned lays out four stages where costs may be incurred.
• 5:24
  SPEAKER_02: And while those four stages are probably a little easier to grasp in the context of self-constructing or building an asset yourself, they do also apply to purchases of assets from third parties too.
• 5:36
  SPEAKER_02: And so those stages are called the preliminary stage, the pre-acquisition stage, the construction stage, and the in-service stage.
• 5:47
  SPEAKER_01: All right.
• 5:48
  SPEAKER_01: So that's a very organized way then for us to talk about it.
• 5:51
  SPEAKER_01: So why don't we start with the preliminary stage and perhaps starting with what exactly do we mean when we say that?
• 5:59
  SPEAKER_02: Sure, sure.
• 6:00
  SPEAKER_02: Well, during this stage, the company is just exploring opportunities about acquiring or constructing PPE.
• 6:08
  SPEAKER_02: It might be conducting feasibility studies or other activities related to selecting assets.
• 6:16
  SPEAKER_02: Some examples of costs and activities that might happen in this stage are things like make versus buy decisions, thinking about design specifications, maybe considering vendors, doing surveying, zoning, engineering studies, things like that, and ultimately getting management's approval to move forward with a particular capital project.
• 6:42
  SPEAKER_02: During the preliminary stage, it's not yet considered probable that an asset will be constructed or purchased.
• 6:49
  SPEAKER_02: So as a result, given the high degree of uncertainty about future economic benefits, costs incurred during this stage are all expensed as they're incurred.
• 6:59
  SPEAKER_01: All right.
• 7:21
  SPEAKER_02: Well, given the nature of how these projects play out and sort of how you might think about what might demonstrate some of that evidence of probability or the likelihood you described?
• 7:33
  SPEAKER_02: You might think about things like has the right level of management authorized and committed to fund the purchase or construction of the asset?
• 7:43
  SPEAKER_02: And is money included in the budget consistent with that authorization?
• 7:48
  SPEAKER_02: And then if you're going to be building the asset yourself, does the company have the ability to meet all the necessary local or other governmental regulations that would be required to be met in order to build the asset?
• 8:04
  SPEAKER_01: All right.
• 8:05
  SPEAKER_01: So then let's move on to the next stage, which is reminders, pre-acquisition stage.
• 8:11
  SPEAKER_01: And what exactly does that mean?
• 8:13
  SPEAKER_02: Well, this is one stage that's probably a bit more limited to assets that are being constructed, like the power plant you mentioned, Heather, rather than purchase.
• 8:23
  SPEAKER_02: The pre-acquisition stage is when the construction of the project is probable.
• 8:29
  SPEAKER_02: You've met some of those other criteria I was just going through to say it's probable, but before the construction actually starts.
• 8:35
  SPEAKER_02: So when you're in this stage, the unissued SOP differentiates between costs that are directly identifiable with the specific project and those that are more of an allocated or overhead cost.
• 8:49
  SPEAKER_02: And it says direct and incremental costs and directly identifiable costs should be capitalized, but any general administrative or overhead costs would be expensed as incurred, and that's regardless of whether you incur them yourself or hire a third party to do some of those activities.
• 9:17
  SPEAKER_02: Well, in this stage, directly identifiable costs might include things like third-party costs that are incremental to buying the PPE, like brokerage fees, for example, if that's part of the process here.
• 9:32
  SPEAKER_02: Might be payroll and related benefit costs for employees who spend time on these activities, maybe like obtaining zoning approval, for example, although it has to be tracked based on the actual time that's spent on that work.
• 9:47
  SPEAKER_02: And then we also see, and maybe a little bit more in the real estate side, there may be costs of an option to purchase the asset, like an option to buy the land.
• 9:56
  SPEAKER_02: If you spend money to buy that option, that cost of that option would be capitalized.
• 10:03
  SPEAKER_01: All right.
• 10:04
  SPEAKER_01: And so then let's talk about probably the immediate stage of a PPE project, and that would be construction.
• 10:10
  SPEAKER_01: So hopefully most people know what construction is, but perhaps you can talk about, you know, what exactly that means from an accounting perspective, and then what types of costs get capitalized.
• 10:21
  SPEAKER_02: Well, you're right.
• 10:22
  SPEAKER_02: That's certainly, this is certainly where most of the costs would get capitalized in a project.
• 10:26
  SPEAKER_02: Uh and this stage would begin when you, the company either obtains or begins to obtain ownership of the actual PPE.
• 10:35
  SPEAKER_02: Uh so that again could be constructing the asset yourself or purchasing it from a third party.
• 10:41
  SPEAKER_02: And here there's costs that are incurred to acquire or construct the asset, as well as to install the PPE.
• 10:50
  SPEAKER_02: And you would consider and probably capitalize all the costs that are incurred before the asset is available for its intended use, which is when capitalization should stop.
• 11:03
  SPEAKER_01: All right.
• 11:04
  SPEAKER_01: And then maybe again to provide some context, what are some of the types of costs that we may see that are incurred during this stage?
• 11:12
  SPEAKER_02: Well, there's certainly lots of costs here that are capitalizable, as you said, into PPE during the construction or acquisition phase.
• 11:18
  SPEAKER_02: Certainly, if you're buying equipment, of course, the purchase price of the item would be the starting point of the cost.
• 11:25
  SPEAKER_02: But also include costs like freight in, sales tax, installation costs.
• 11:32
  SPEAKER_02: Those are all directly associated with getting the PPE into its condition and location for use.
• 11:39
  SPEAKER_02: If you're building an asset, you can capitalize the payroll and related benefit costs of employees who spend time on the construction of the PPE, again, based on their actual time incurred.
• 11:51
  SPEAKER_02: And you can also capitalize the cost to run the machinery and equipment in order to test that the output would meet, say, certain regulatory specifications, like in the pharmaceutical industry.
• 12:04
  SPEAKER_02: Then there's also some indirect costs that can be capitalized, like depreciation of machines and equipment that are used directly in the construction or installation of the PPE.
• 12:16
  SPEAKER_02: If you're actually using machines to build something else, you can capitalize some of the depreciation costs associated with those machines based on the proportion of the time that the machines are being used for that purpose, along with incremental costs of using them, like fuel costs or things like that.
• 12:33
  SPEAKER_02: And then lastly, you you might have some inventory that's used directly in the construction or installation of PPE, like spare parts.
• 12:42
  SPEAKER_02: Those could also be capitalized.
• 12:44
  SPEAKER_02: Now, one thing that is not capitalizable though is rent depreciation and other occupancy costs associated with the physical space that's going to house the PPE.
• 12:58
  SPEAKER_02: And that's true even if you're building out rented space, say with your furniture and fixtures and aren't ready to fully use the space yet.
• 13:07
  SPEAKER_02: So an example we often run into with this would be if you rent store space, but it's going to take, say, six months to get the store to look and feel like your other stores before you're actually going to open it and start to use the store, so to speak.
• 13:23
  SPEAKER_02: You can't defer or capitalize the rent costs that you're incurring during that period of time, uh, because that's not really associated with the fixed assets themselves.
• 13:34
  SPEAKER_02: And this was a big issue that a number of companies ran into some years ago.
• 13:37
  SPEAKER_02: It was actually for a number of restatements associated with this some years ago.
• 13:41
  SPEAKER_01: Yes, I think this is definitely one that is a very good reminder because it feels the same as other costs that are eligible to be capitalized.
• 13:50
  SPEAKER_01: So definitely one uh to look out for.
• 13:53
  SPEAKER_01: And then, Jay, I know we haven't quite finished all the stages, but I want to talk about one specific type of cost.
• 13:59
  SPEAKER_01: And, you know, obviously, particularly, let's think about power plant or some other big building or something else.
• 14:06
  SPEAKER_01: Definitely can take a long time to get that done.
• 14:09
  SPEAKER_01: And often, I think it's a very frequent model, companies would be taking out debt to finance the construction project, or maybe they just have debt in their capital structure.
• 14:18
  SPEAKER_01: So capitalized interest is also a big cost or a big place where we get a lot of questions.
• 14:24
  SPEAKER_01: What is the overview of when you do capitalize and some of the things to consider?
• 14:30
  SPEAKER_02: Right.
• 14:30
  SPEAKER_02: Yeah, that's definitely one that we get a fair number of questions about.
• 14:34
  SPEAKER_02: Uh, because the guidance says, as you were alluding to, that if an asset requires a period of time to get it ready for its intended use, then the interest cost incurred during that period on the asset expenditures is part of the cost of the asset.
• 14:52
  SPEAKER_02: And interestingly, or maybe as a surprise to some of our listeners, capitalizing interest isn't optional.
• 14:59
  SPEAKER_02: You can't just elect not to do it.
• 15:02
  SPEAKER_02: Uh, although you do have to apply judgment in determining whether the interest associated with these assets would have a material effect on the financial statements if it isn't capitalized, because the guidance does have some concepts about that baked in of sort of how long is it going to take, how much are the costs being incurred, does it really have a significant impact or not?
• 15:21
  SPEAKER_02: So there's some judgment involved, but you can't just sort of decide, oh, I'm not going to capitalize interest on this project.
• 15:29
  SPEAKER_01: Right.
• 15:29
  SPEAKER_01: And I do think that's another area where people often think, oh, well, I just don't want to, or whatever else, but that's definitely not an option.
• 15:37
  SPEAKER_01: I will say for the power and utility audience, we have our own uh capitalized interest.
• 15:42
  SPEAKER_01: I'll use that in quotes because it's actually the one case you get an equity component, but that's very specific for power and utility companies, so not for others, but they don't always just follow this regular capitalized interest model for that reason.
• 15:55
  SPEAKER_01: So then, Jay, for capitalized interest itself, I think one of the biggest places where we get questions, and I know sometimes there can be issues or it can be confusing, is when do you start and stop capitalizing interest expense?
• 16:11
  SPEAKER_02: What the guidance says is that you would start capitalizing interest when three conditions are all present.
• 16:19
  SPEAKER_02: Uh the first that is that there's been qualifying expenditures for the asset as defined in the guidance.
• 16:26
  SPEAKER_02: The activities necessary to get the asset ready for its intended use are in progress, and the company is incurring interest costs that can be capitalized.
• 16:36
  SPEAKER_02: And then basically, interest capitalization would continue as long as all those three conditions are being met.
• 16:44
  SPEAKER_02: And then on the other end, you would stop capitalizing interest when the asset is ready for its intended use, or if substantially all activities associated with constructing the asset have been suspended.
• 16:58
  SPEAKER_02: Now, brief interruptions in construction or interruptions that are externally imposed, maybe to do some checks on things by regulators or the like, or delays that are inherent in the asset construction process wouldn't require you to stop capitalizing interest.
• 17:16
  SPEAKER_02: But the guidance does say you shouldn't be capitalizing interest if construction is intentionally delayed by the company.
• 17:24
  SPEAKER_01: So, Jay, this is past, um, and it's just my curiosity.
• 17:27
  SPEAKER_01: But so if I think about COVID, so many construction projects were stopped because they were forced to shut down.
• 17:35
  SPEAKER_01: So it's not voluntary, but I would have thought that would be a circumstance that you would have stopped.
• 17:41
  SPEAKER_01: Is there an easy answer?
• 17:43
  SPEAKER_01: Is this one we should just say, that's in the past, let's focus on the current circumstances?
• 17:49
  SPEAKER_02: Yeah, um fair fair point.
• 17:52
  SPEAKER_02: I mean, I think that sort of gets into some of the judgment maybe around what a brief interruption in construction is.
• 17:57
  SPEAKER_02: So if it's a short period of time, maybe you would keep on going.
• 18:01
  SPEAKER_02: It was just part of all called the normal ebbs and flows of construction, right?
• 18:05
  SPEAKER_02: There's always going to be a little bit of stops and starts uh for waiting for materials or the like.
• 18:10
  SPEAKER_02: But I think something like COVID, where maybe things were shut down for many months or years uh at a time, that that's probably a little bit um a little bit beyond what the guidance would contemplate there.
• 18:22
  SPEAKER_01: All right.
• 18:22
  SPEAKER_01: Well, that's hopefully information we are not going to need in the future.
• 18:26
  SPEAKER_01: So we don't have to dwell more on that.
• 18:28
  SPEAKER_01: So then let's go back to actually capitalizing interest.
• 18:31
  SPEAKER_01: How do you calculate the amount that you're going to capitalize?
• 18:35
  SPEAKER_02: Well, it's calculated by multiplying a capitalization rate by the weighted average cumulative amount of expenditures for the assets during the period.
• 18:48
  SPEAKER_02: Now, there's some flexibility in the guidance in determining the capitalization rate.
• 18:53
  SPEAKER_02: It can be the rate of a specific new borrowing that's directly associated with the asset construction, or it can be more of a weighted average rate based on the company's overall borrowings and its capital stack, as you mentioned.
• 19:07
  SPEAKER_02: We generally think the weighted average technique makes the most sense since proceeds from a specific borrowing are typically not identifiable to a particular PP ⁇ project and money is fungible.
• 19:19
  SPEAKER_02: But if there is a specific loan made for a specific project, it's certainly reasonable to use that as part of figuring out the right interest capitalization rate.
• 19:29
  SPEAKER_02: The general idea is that we're trying to get a reasonable measure of the cost of financing the asset while getting it ready for its intended use, or in other words, the interest cost that could have been avoided if the company wasn't constructing the asset.
• 19:44
  SPEAKER_02: And because it's based on cash borrowings, the accumulated qualifying expenditures, which I said before, is the amount that's multiplied by the capitalization rate to figure out how much interest to capitalize, that's looked at on a cash basis rather than on an accrual basis.
• 20:01
  SPEAKER_02: So I guess unless the accruals themselves bear interest because you're trying to figure out how much interest is the company incurring, which is based on borrowings that the company is actually taken out.
• 20:11
  SPEAKER_01: Right.
• 20:11
  SPEAKER_01: And I think, Jay, a key point there is particularly in that case when you may have like a construction-specific borrowing, you are still basing it on your qualifying expenditures.
• 20:22
  SPEAKER_01: So, for example, if you've taken more money down on that loan, you can't just say, oh, well, this loan's for this project, I'm going to capitalize all my interest.
• 20:29
  SPEAKER_01: That's another trap I've seen people fall into.
• 20:32
  SPEAKER_01: So then that's construction.
• 20:34
  SPEAKER_01: And as we suggested, that is the one of the biggest stages to think about.
• 20:39
  SPEAKER_01: But then we get to what's perhaps in some ways the most important stage, which is the in-service stage.
• 20:45
  SPEAKER_01: So what do you think about then?
• 20:46
  SPEAKER_02: So that stage, the in-service stage, that that kicks in when the asset is substantially complete and ready for its intended use.
• 20:56
  SPEAKER_02: Doesn't actually have to be placed in service, but it's ready to go in essence.
• 21:01
  SPEAKER_02: So costs that we might see getting incurred during this stage would be things like repairs and maintenance of existing components, replacing existing components, or maybe purchases of additional components to expand what the uh the equipment does.
• 21:17
  SPEAKER_02: So costs that a company might incur to acquire additional components of PPE or replace existing components are generally going to be capitalized.
• 21:42
  SPEAKER_02: But on the other hand, the costs of normal, recurring, or periodic repairs and maintenance activities and all other costs that a company spends on PPE during this stage should all get expensed as incurred, and that would include things like teaching people how to use a new machine for.
• 22:00
  SPEAKER_01: And then Jay, I want to come back to maintenance because I know that's another area that can get complicated and definitely one I'm quite interested in.
• 22:08
  SPEAKER_01: But just one other question.
• 22:09
  SPEAKER_01: I know that we're not talking about depreciation here, but is this then is that point when it's in service that would typically be also the point that the company would be starting to depreciate the asset?
• 22:21
  SPEAKER_01: Is that right?
• 22:22
  SPEAKER_02: Well, Heather, I think we will talk a little bit more about depreciation, think about like methods and lives a little bit later on.
• 22:28
  SPEAKER_02: But I I think in terms of like when depreciation would start, depreciation probably would start when you actually place it in service and you're starting to use it.
• 22:36
  SPEAKER_02: So there could conceptually be a period of time when you're you're done building it or done installing it and you should stop capitalizing the costs, but you actually haven't placed it in service yet to start depreciating it.
• 22:48
  SPEAKER_02: So it could just kind of be sitting there in suspended animation waiting to start depreciation.
• 22:53
  SPEAKER_02: But we don't tend to necessarily see a long period of time in between those.
• 22:57
  SPEAKER_01: Okay, that's helpful.
• 22:59
  SPEAKER_01: So then, Jay, let's go back to maintenance.
• 23:00
  SPEAKER_01: So you were talking about, I'll call it like sort of regular maintenance, but there's definitely also a concept of major maintenance for different types of assets, including power plants.
• 23:11
  SPEAKER_01: But I know many others, airlines have them too, and I think we're going to talk about that.
• 23:14
  SPEAKER_01: So can you describe for the audience what we mean when we say major maintenance, and then we'll talk about some of the accounting challenges?
• 23:21
  SPEAKER_02: Sure, yeah, you're right.
• 23:22
  SPEAKER_02: It is an interesting concept, kind of term of art used in certain industries to describe a sort of major overhaul of a large asset that has to be done periodically to keep it running or to meet certain regulatory requirements beyond kind of the day-to-day servicing and upkeep of it.
• 23:43
  SPEAKER_02: And it's usually the type of thing that takes a fair bit of time to get done.
• 23:47
  SPEAKER_02: So, along with taking a power plant offline, like you mentioned, think of putting a ship in the dry dock or taking apart an airplane engine after so many flight hours and replacing a number of components.
• 23:59
  SPEAKER_02: Uh, and actually kind of building on that airplane one.
• 24:01
  SPEAKER_02: You know, in fact, the limited amount of accounting guidance we have on this topic is in the airlines industry section of the FASBI's guidance, as well as the AICPA's audit and accounting guide for airlines.
• 24:13
  SPEAKER_02: But it is generally applied by analogy to other industries.
• 24:18
  SPEAKER_02: And the treatment of the costs themselves will generally depend on whether they meet the criteria in the FASBES concept statements for the recognition as an asset.
• 24:30
  SPEAKER_02: Major repair and maintenance programs that result in future economic benefit and extend the life of the asset, which is generally what they're designed to do here, they may very well qualify for capitalization.
• 24:41
  SPEAKER_01: All right.
• 24:41
  SPEAKER_01: And then if we are in a major maintenance situation, what are the accounting models that companies can look at?
• 24:50
  SPEAKER_02: Well, if you have major maintenance, the guidance says that there are three acceptable methods to account for them.
• 24:57
  SPEAKER_02: One way is to just expense the costs as incurred.
• 25:01
  SPEAKER_02: And the thought here is that if you're a company that has a fleet of items that are all going to need major maintenance at some point, you'll probably be doing some each period just from an operational perspective.
• 25:12
  SPEAKER_02: And therefore the costs will be incurred each period in a relatively constant way.
• 25:18
  SPEAKER_02: So it might just make sense to just expense the cost of overhauls as incurred, like any other maintenance costs.
• 25:25
  SPEAKER_02: The second way the guidance talks about is a deferral or capitalization approach.
• 25:30
  SPEAKER_02: So under that approach, the costs of the overhaul are capitalized and depreciated over the period to the next overhaul is going to take place.
• 25:40
  SPEAKER_02: And then the third way is kind of a variation of the second.
• 25:43
  SPEAKER_02: It's called the built-in overhaul method.
• 25:45
  SPEAKER_02: And what that does is it takes the cost of the items that are going to need to be overhauled and segregates them out from the initial purchase or construction price of the larger assets.
• 25:57
  SPEAKER_02: When you bought the asset in the first place, you actually separate kind of the things that you know are gonna need to be overhauled from the rest of the asset's costs.
• 26:06
  SPEAKER_02: And that first group of costs, the ones that are going to be overhauled, those will get depreciated over the period until that first overhaul takes place.
• 26:14
  SPEAKER_02: And at that time, you'll take the costs of the major maintenance and capitalize those and depreciate those until the next overhaul takes place.
• 26:22
  SPEAKER_02: And then the cost of the rest of the asset, that would just get depreciated over the longer useful life of the asset.
• 26:28
  SPEAKER_01: All right.
• 26:29
  SPEAKER_01: Lots of tracking in that, in that method.
• 26:31
  SPEAKER_02: All right, so then what does the AICPA airline guide tell us about the Well, interestingly, the AICPA airline guide, and maybe because it's dealing with airlines that have a fleet of planes and engines that are going to be dealt with all the time, they say that the expense does incurred method, that first method I mentioned, that's actually preferable.
• 26:52
  SPEAKER_02: Although we do see all three methods in practice.
• 26:55
  SPEAKER_02: But whatever method you choose for major maintenance, that's an accounting policy election, that should be applied consistently.
• 27:02
  SPEAKER_02: But while the guide talks about these three acceptable methods, it also says there is one explicitly unacceptable method.
• 27:09
  SPEAKER_02: And that is that you cannot accrue the costs of future major maintenance in advance of the maintenance actually taking place.
• 27:19
  SPEAKER_02: And the thought here is then, unlike asset retirement obligations, the company has no present legal obligation to perform the major overhaul because you could always just decommission or scrap the asset before needing to perform the major maintenance.
• 27:36
  SPEAKER_02: So that's why you don't accrue it before it actually happens.
• 27:39
  SPEAKER_02: You have to wait until the costs are actually incurred.
• 27:42
  SPEAKER_01: All right.
• 27:43
  SPEAKER_01: And I can say from my own experience, the expenses incurred method is definitely the easiest.
• 27:49
  SPEAKER_01: So if you are looking for an easier method to apply, that's going to be the one that's going to be the most straightforward.
• 27:55
  SPEAKER_01: So perhaps, you know, to your point, that is why uh the airline guide puts that, you know, as preferable.
• 28:02
  SPEAKER_01: So then, Jay, I know another sort of nuance with dealing with major maintenance is that often a company will pay a third party to actually take care of the major maintenance.
• 28:12
  SPEAKER_01: And that might even include, you know, you have a contract, you make a monthly payment, so everything gets kind of leveled out.
• 28:20
  SPEAKER_01: So that inherently does not seem to match up with at least the last method that you said, you know, that you cannot follow.
• 28:28
  SPEAKER_01: But how do companies think about applying these different methods when you do have that type of contract?
• 28:36
  SPEAKER_02: Right.
• 28:36
  SPEAKER_02: And you're right.
• 28:37
  SPEAKER_02: Generally, the existence of these contracts won't really change the fundamental underlying notion here.
• 28:45
  SPEAKER_02: I mean, true of a lot of other service contracts and service agreements, that regardless of when you pay for them, the cost should be recognized when the services are performed.
• 28:57
  SPEAKER_02: And the monthly payments, really just more of a funding or cash flow mechanism and might just result in a prepaid for future services.
• 29:05
  SPEAKER_02: But there are a couple of permutations of these arrangements, and they sometimes can get a little complicated as to who's absorbing the risks of the actual ultimate cost that will be incurred.
• 29:17
  SPEAKER_02: And so if you have these, it's probably worth going through the guidance to take a look.
• 29:20
  SPEAKER_02: But the general idea is that you incur the costs when you incur the cost and not necessarily when you write a check for them.
• 29:29
  SPEAKER_01: Well, I think in general, if you're dealing with major maintenance, is actually definitely worth reading that AICPA airline guide.
• 29:36
  SPEAKER_01: It does lay out the methods very clearly, and I think it has some helpful guidance.
• 29:39
  SPEAKER_01: So highly encourage you to do that in any event.
• 29:43
  SPEAKER_01: But so, Jay, now we've figured out how much we're capitalized, and let's presume we have now actually put this asset in service.
• 29:51
  SPEAKER_01: So maybe we had our ribbon cutting ceremony or whatever else.
• 29:54
  SPEAKER_01: So, what should companies then be thinking about?
• 29:56
  SPEAKER_02: I like that uh visual there.
• 29:59
  SPEAKER_01: Exactly, right?
• 30:00
  SPEAKER_01: Can't you see the big scissors?
• 30:02
  SPEAKER_02: So can you capitalize the big scissors?
• 30:04
  SPEAKER_02: I don't know that's another question from a question.
• 30:07
  SPEAKER_02: Um Well, part of the model for PPE, as we've mentioned before, is the process of depreciation.
• 30:13
  SPEAKER_02: And that's really just described as a cost allocation technique.
• 30:18
  SPEAKER_02: It's a way of recognizing that historical cost that we've been talking about over the useful life of the asset in a way that it just allocates the cost as equitably as possible to the periods that the asset is going to be used.
• 30:33
  SPEAKER_02: And there's several depreciation methods in practice that might achieve that objective of recognizing the cost of the PPE asset, plus any salvage value if there are some, over its estimated useful life in a systematic and rational manner.
• 30:49
  SPEAKER_02: So we see things like the straight line method, certainly probably easiest, and maybe see that a lot, but we see that.
• 30:55
  SPEAKER_02: We see accelerated methods like declining balance methods or the sum of the year's digits methods, as well as units of production method that would allocate the cost based on how much the machine is being used.
• 31:08
  SPEAKER_02: Now, I really won't go into the mechanics of the different methods, because there's lots of counting textbooks and other stuff that talks about those.
• 31:17
  SPEAKER_02: But when you're selecting a method of depreciation for a given asset, you'd probably want to think of things like whether the asset is subject to rapid obsolescence, uh, whether deterioration of the asset is more a function of time or of usage, if the productivity of the asset declines with time, and sort of how does that productivity decline over time, and if the cost of repair and maintenance for the asset would increase as time goes by.
• 31:47
  SPEAKER_02: Now, interestingly, unlike most accounting method decisions, this isn't a company-wide policy that you have to apply to all your PPE assets.
• 31:57
  SPEAKER_02: You can apply different depreciation methods to different kinds of assets depending on those facts and circumstances I was just going through.
• 32:04
  SPEAKER_02: In fact, we often see companies apply different methods and techniques to different kinds of assets.
• 32:10
  SPEAKER_02: Uh, and whatever method you choose, then you also have to determine the useful life and the salvage or residual value of the asset.
• 32:17
  SPEAKER_02: And there's definitely a lot of judgment that goes into that.
• 32:20
  SPEAKER_02: But some factors the guidance talks about in making that judgment would be things like the expected use of the asset by the company and how long you think they're gonna use it for, any legal or regulatory or contractual provisions that may limit the useful life of the asset.
• 32:39
  SPEAKER_02: For example, like leasehold improvements that are gonna have to go back to the landlord at the end of at the end of the lease term.
• 32:45
  SPEAKER_02: Uh, and the effect of things like obsolescence or demand or competition or any other economic factors that, you know, what that what that could mean to the likely life of the asset.
• 32:56
  SPEAKER_01: All right.
• 32:56
  SPEAKER_01: So then, Jay, anytime we're dealing with these types of estimates, I think a question comes up of the frequency of reassessment.
• 33:03
  SPEAKER_01: And I know you and I have talked about others.
• 33:05
  SPEAKER_01: I think even some of our stock comp that we said you kind of had to relook at each period.
• 33:10
  SPEAKER_01: Would we put useful lives and salvage values into that category, or how do you think about those?
• 33:16
  SPEAKER_02: Well, that there's no explicit requirement in the guidance to reevaluate the useful lives of long live tangible assets every reporting period.
• 33:27
  SPEAKER_02: But we do believe a company should reassess the useful lives of PP and E whenever events or circumstances might indicate that it makes sense to do that.
• 33:36
  SPEAKER_01: All right.
• 33:36
  SPEAKER_01: And then Jay, I think a good example of that is an intersection with a lot of the other work we're doing, which is ESG.
• 33:43
  SPEAKER_01: But can you explain how ESG would come into this conversation and how you might think about that?
• 33:48
  SPEAKER_02: Yeah, that's definitely a common one we've been we've been running into.
• 33:52
  SPEAKER_02: So suppose a company has a piece of equipment that it's using and it's being depreciated over an expected useful life of 10 years, let's say.
• 34:02
  SPEAKER_02: And we're at the end of the fourth year, and maybe due to the company's new ESG strategy, the company expects to only use the equipment in its operations for another, say, year, another 12 months, because the company is going to acquire a new piece of equipment that significantly reduces the emissions of greenhouse gases during the production process.
• 34:26
  SPEAKER_02: And then the company's plan is just to get rid of the existing machine, and because of these sort of changes and dynamics, it doesn't really think that anyone's going to buy it at that point.
• 34:35
  SPEAKER_02: So in that case, the company would need to rethink its depreciable lives, its estimated useful life, and probably in this case depreciate that remaining carrying amount of the asset with no salvage value, because it doesn't expect to get anything for it over the next 12 months, kind of the remaining period of time it's going to use it.
• 34:56
  SPEAKER_02: But because, as you said, that this is considered a change in estimate under the accounting guidance, the change in useful life is just accounted for prospectively.
• 35:05
  SPEAKER_02: So you would take the remaining carrying value and you sort of decide you need to change your life and just depreciate it over the remaining in this case shorter period of time.
• 35:15
  SPEAKER_02: There's no cumulative catch-up of how much depreciation would have been if you had been using that new useful life the whole time.
• 35:23
  SPEAKER_01: Right.
• 35:23
  SPEAKER_01: And I think often companies may want to do that catch-up so they can kind of normalize expense in that last period.
• 35:30
  SPEAKER_01: But I so I think again, that's a great reminder that if it's prospective, then you just use that new period.
• 35:36
  SPEAKER_01: So, Jay, definitely a lot of pitfalls that we've talked about today, and I think some great reminders.
• 35:42
  SPEAKER_01: From your perspective, then sort of final thoughts for our audience as they're thinking about dealing with these types of issues.
• 35:49
  SPEAKER_02: Well, maybe I'll mention something.
• 36:02
  SPEAKER_02: And that's the notion of using a capitalization threshold for PPE.
• 36:08
  SPEAKER_02: Um, you know, we know that for ease of record keeping, a lot of companies may establish a some dollar threshold amount uh before they would capitalize the costs into PPE and put them into their fixed asset records and the like.
• 36:24
  SPEAKER_02: And the thought behind that is that whether the company capitalizes and depreciates the costs or just expenses the costs as they're incurred, it wouldn't be material to the financial statements.
• 36:38
  SPEAKER_02: But that just means it's really just being done for administrative convenience.
• 36:44
  SPEAKER_02: Uh, it's not really an accounting policy.
• 36:47
  SPEAKER_02: Uh, but a lot of companies, a lot of people might think that it is and ask questions about well, we used to only capitalize amounts above this amount of money, and now we want to change that to a different amount of money.
• 37:00
  SPEAKER_02: Is that an accounting policy change?
• 37:02
  SPEAKER_02: Do we have to go back and recalculate everything using that new policy?
• 37:05
  SPEAKER_02: And it's actually not a policy at all.
• 37:07
  SPEAKER_02: It's really just uh the pa the right gap is that you're supposed to capitalize everything theoretically and appreciate it.
• 37:13
  SPEAKER_02: But of course, you know, you gotta you gotta make reasonable uh administrative cuts depending on the materiality of things to your organization.
• 37:21
  SPEAKER_02: So we do get that question a lot.
• 37:22
  SPEAKER_02: It's an interesting one, but but you won't find that anywhere in the codification around what to do about that.
• 37:28
  SPEAKER_01: I bet a lot of people will be appreciative that you address that in this podcast, though, Jay.
• 37:33
  SPEAKER_01: So thank you for that thought.
• 37:35
  SPEAKER_01: Um so then almost at the end of the podcast, and my usually second to last question, penultimate question, would be where should you go for more information?
• 37:45
  SPEAKER_02: Well, everything we've talked about today is covered in more detail in our PPE and other assets guide, especially chapter one, and you've mentioned the airlines audit guide as well that that's out there along with the FASBES codification.
• 38:01
  SPEAKER_02: But uh, we talk a lot about a lot of this stuff a bit more and a bit more of the judgments involved in our guide.
• 38:06
  SPEAKER_02: Uh and we also have a number of podcasts where we've talked about asset acquisitions, uh, I think even some ESG webcasts that we've done together, we've talked about some of the implications of evolution of uh your ESG strategy on fixed assets and appreciable lives and things like that.
• 38:24
  SPEAKER_02: So listeners can definitely check out all those in our library.
• 38:27
  SPEAKER_01: All right, helpful, and we'll definitely put some links to those in the show notes.
• 38:31
  SPEAKER_01: So as I said, that was not my final question, because as Jay very well knows, final questions are always stump the guests.
• 38:38
  SPEAKER_01: I have two good ones here today.
• 38:40
  SPEAKER_01: First one is open-ended, but second one, just to get your mindset in the right place, that one will be multiple choice.
• 38:46
  SPEAKER_01: So you're gonna at least move to maybe perhaps an easier question.
• 38:50
  SPEAKER_01: So this one, since we're talking about fixed assets, which country has eight of the 15 tallest buildings in the world?
• 39:00
  SPEAKER_01: I'll tell you right now, I guessed wrong mentally, but when I saw the answer.
• 39:05
  SPEAKER_02: So well, I know the biggest ones in the world are in various parts of the Middle East and Asia, but I'm gonna say the US, if we're talking about quantity, uh the US has its share of big buildings.
• 39:17
  SPEAKER_02: So I'm gonna go with the US.
• 39:19
  SPEAKER_01: All right, so you were actually clonally in the right place with your first part of the response because actually eight of the 15 tallest buildings in the world are in China.
• 39:31
  SPEAKER_01: So I was definitely like I said, I was surprised by that response.
• 39:34
  SPEAKER_01: And then the world's tallest building is in Dubai.
• 39:37
  SPEAKER_01: So you were correct about the Middle East there.
• 39:40
  SPEAKER_01: All right.
• 39:41
  SPEAKER_01: So then this next question is building on that, but again, multiple choice.
• 39:46
  SPEAKER_01: How tall is the tallest building in China, which is the second tallest building in the world, and that's the Shanghai Tower.
• 39:53
  SPEAKER_01: So your choices are 1,000 feet, 1,500 feet, 2,000 feet, or 3,000 feet.
• 40:00
  SPEAKER_02: I think is the I'm not sure if the Shanghai Tower is also called the World Trade Center there.
• 40:05
  SPEAKER_02: I've I've had the opportunity to be up in that building once.
• 40:07
  SPEAKER_01: Oh, interesting.
• 40:08
  SPEAKER_02: But that was enough years ago that I can't say I remember exactly how big it is.
• 40:12
  SPEAKER_02: I know it's not the first couple, because I know the uh the you know the the tallest one in the US is is uh is is over almost 1800 feet.
• 40:23
  SPEAKER_02: So what were the last two choices again, Heather?
• 40:26
  SPEAKER_01: So second last two were 2,000 or 3,000.
• 40:29
  SPEAKER_01: And I will confirm you are right, the tallest in the US is the um One World Trade Center, which is 1,776 feet.
• 40:38
  SPEAKER_01: So that's the sixth largest building in the world.
• 40:40
  SPEAKER_02: So since you already had eliminated those other choices, I'm sure that that height is not by accident as to where that where the building came up with that number.
• 40:48
  SPEAKER_01: Yes.
• 40:49
  SPEAKER_02: Um I'm gonna go with 2,000 feet.
• 40:51
  SPEAKER_02: I can't imagine.
• 40:52
  SPEAKER_01: All right, go thing.
• 40:53
  SPEAKER_02: That you know, almost 50% bigger than that one.
• 40:57
  SPEAKER_01: Yep.
• 40:58
  SPEAKER_01: I I had 3,000, that would be a tall, tall building.
• 41:01
  SPEAKER_01: So yes, it is 2,000 feet.
• 41:03
  SPEAKER_01: So very good guessing, and even your knowledge of tall buildings, I'm impressed with.
• 41:07
  SPEAKER_01: So I'm not sure I would have been able to pull out the even the US's tallest, tallest building on the spot.
• 41:13
  SPEAKER_01: So, Jay, it's always such a pleasure to have you on.
• 41:15
  SPEAKER_01: Thanks so much for joining me.
• 41:19
  SPEAKER_01: That's our show for today.
• 41:21
  SPEAKER_01: We'll be back next Tuesday to wrap up our October Toolkit series with a discussion of considerations for fixed assets that are held for sale.
• 41:29
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• 41:32
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• 41:37
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• 41:47
  SPEAKER_01: From Thought Leadership at PwC, I'm Heather Horn.
• 41:51
  SPEAKER_01: Thanks for tuning in.
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