6.1 Determining costs of assets as per Accounting standards

The cost of a non-current asset is the total amount an organisation spends to acquire the asset and bring it to the place and condition where it can be used as management intends. Accounting standards, namely IAS 16 Property, Plant and Equipment for private entities and IPSAS 17 for public sector bodies such as county governments, state how this cost is to be built up. Getting the cost right matters because it is the figure on which depreciation is calculated, and it decides how much of each payment is shown as an asset in the statement of financial position and how much is charged as an expense in the profit and loss account. Example: a poultry farm in Naivasha imports an egg-grading machine and must decide which of the many bills connected with it form part of the machine's cost.

6.1.1 Recognition of an item as a non-current asset

Before a cost is determined, the item must qualify as an asset. An item is recognised when it is probable that future economic benefits will flow to the organisation and the cost can be measured reliably.

• Held for use: The item is kept to produce goods, supply services, rent to others or run the administration, and not to be sold in the ordinary course of business.
• Used for more than one period: The item is expected to serve the organisation for longer than one year.
• Future benefits are probable: The organisation will gain income or service potential from it, such as a vehicle that delivers goods.
• Cost can be measured reliably: There is an invoice, contract or other evidence of what was paid.
• Control: The organisation owns the item or controls it through a finance lease, and carries the risks and rewards of its use.
• Capitalisation threshold: Many organisations set a minimum amount, for example Ksh 50,000, below which an item is treated as an expense even if it lasts several years.

6.1.2 Elements included in the cost of an asset

Under the standards the cost of an item of property, plant and equipment comprises three elements.

Purchase price

The invoice price of the asset, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. Example: a contractor in Thika buys a lorry with a list price of Ksh 3,000,000 and receives a 10% trade discount, so the purchase price is 3,000,000 − (3,000,000 × 10%) = 3,000,000 − 300,000 = Ksh 2,700,000.

Directly attributable costs

Costs that arise directly from bringing the asset to its location and working condition.

• Delivery and handling: Transport, freight, insurance in transit and loading charges.
• Site preparation: Levelling, foundations and building works needed before the asset can be installed.
• Installation and assembly: Fees paid to the installer and the cost of connecting the asset to power and water.
• Testing: The cost of checking that the asset works properly, less the proceeds from selling any items produced during testing.
• Professional fees: Payments to architects, engineers, surveyors and lawyers, such as legal fees and stamp duty on land.
• Employee costs: Wages and benefits of staff who work directly on constructing or installing the asset.
• Registration and licensing: Fees paid to make the asset legal to use, such as vehicle registration and number plates.

Initial estimate of dismantling and restoration costs

Where the organisation must remove the asset and restore the site at the end of its life, the present value of the estimated cost is added to the asset when it is first acquired, with a matching provision recorded as a liability. Example: a quarrying company in Kitui that must restore the land after use includes the estimated restoration cost in the cost of its crushing plant.

6.1.3 Costs excluded from the cost of an asset

• Administration and general overheads: Costs such as head office salaries and general running costs are not directly attributable to the asset.
• Staff training costs: Training employees to operate the asset is an expense, not part of its cost.
• Opening costs: The cost of opening a new branch or launching a new product, including advertising and promotion.
• Initial operating losses: Losses made while demand builds up, or while the asset runs below capacity.
• Abnormal waste: Wasted materials, labour or other resources beyond the normal level, for example materials damaged by poor site control.
• Recoverable taxes: VAT that the organisation can claim back from the Kenya Revenue Authority is not part of cost. VAT that cannot be recovered, for example by an entity making exempt supplies, is added to cost.
• Costs after the asset is ready for use: Relocating the asset or running costs incurred once it is able to operate are expenses.
• Maintenance and routine repairs: Day to day servicing is charged to the profit and loss account.

6.1.4 Capital expenditure and revenue expenditure

Spending is either capital, which adds to the cost of an asset, or revenue, which is charged as an expense. Treating a capital item as an expense understates profit and assets, and treating an expense as an asset overstates them, as explained for errors of principle.

6.1.5 Special cases in determining cost

• Deferred payment: If payment is spread over a long period, the cost is the cash price at the date of purchase. The extra amount is interest and is charged as an expense over the credit period.
• Self-constructed assets: The cost is the same as for a purchased asset: materials, direct labour and other directly attributable costs, without any profit margin.
• Land and buildings bought together: The total price is divided between land and building, because land is not depreciated and buildings are. The split is based on a valuation or other fair basis.
• Exchange of assets: The new asset is measured at the fair value of the asset given up, unless the exchange has no commercial substance.
• Assets received as a grant or donation: The asset is measured at its fair value at the date it is received, as under IPSAS 17.
• Borrowing costs: Interest on loans taken to finance a qualifying asset that takes a long time to build, such as a hospital block, is added to cost during the construction period under IAS 23.
• Subsequent expenditure: Money spent later is added to cost only if it increases future benefits, for example by extending life or capacity.

6.1.6 Steps in determining the cost of an asset

1. Confirm that the item qualifies as an asset: Check that it is held for use, lasts more than one year and is above the capitalisation threshold.
2. Record the purchase price: Take the invoice price including duties and non-refundable taxes.
3. Deduct trade discounts and rebates: Reduce the price by discounts allowed on the invoice.
4. Add directly attributable costs: Include delivery, site preparation, installation, testing and professional fees, each supported by an invoice or voucher.
5. Add the estimate for dismantling and restoration: Include it where the organisation has an obligation.
6. Remove excluded items: Take out administration, training, recoverable VAT and other costs that do not form part of cost.
7. Calculate the total cost: Add the included elements to obtain the amount at which the asset is recognised.
8. Document and approve: File the supporting documents and obtain approval from the finance manager before the cost is recorded in the asset register.

6.1.7 Worked examples

Example 1: a poultry farm in Naivasha imports an egg-grading machine. The costs were:

Formula: cost = purchase price + import duty + freight + installation + testing

Substitution: 2,000,000 + 250,000 + 80,000 + 120,000 + 30,000

Working: 2,000,000 + 250,000 = 2,250,000, then + 80,000 = 2,330,000, then + 120,000 = 2,450,000, then + 30,000 = 2,480,000

Result: cost of the machine = Ksh 2,480,000

Training of Ksh 40,000 is charged as an expense and recoverable VAT of Ksh 320,000 is claimed from the Kenya Revenue Authority.

Example 2: a contractor in Thika buys a lorry with a list price of Ksh 3,000,000, a trade discount of 10%, delivery of Ksh 20,000, registration fees of Ksh 15,000, and a first year insurance of Ksh 60,000.

Purchase price: 3,000,000 − (3,000,000 × 10%) = 3,000,000 − 300,000 = Ksh 2,700,000

Cost: 2,700,000 + 20,000 + 15,000 = Ksh 2,735,000

The insurance of Ksh 60,000 is an expense of the year.

Example 3: a county hospital in Kisii builds a new ward using its own workers. The costs were materials Ksh 4,500,000, direct labour Ksh 1,800,000, architect's fees Ksh 300,000, wasted materials from poor storage Ksh 120,000 and a share of general administration Ksh 200,000.

Cost: 4,500,000 + 1,800,000 + 300,000 = Ksh 6,600,000

The abnormal waste of Ksh 120,000 and the administration share of Ksh 200,000 are charged as expenses.

Example 4: a SACCO in Nyeri buys office equipment on credit. The cash price is Ksh 1,200,000, and it will pay 24 monthly instalments of Ksh 60,000.

Total paid: 24 × 60,000 = Ksh 1,440,000

Interest: 1,440,000 − 1,200,000 = Ksh 240,000

Cost of the asset = cash price = Ksh 1,200,000, and the Ksh 240,000 is interest expense spread over the 24 months.

Example 5: a school in Eldoret buys land with a building for Ksh 9,000,000. A valuer states that the land is worth 40% of the total.

Land: 9,000,000 × 40% = Ksh 3,600,000

Building: 9,000,000 − 3,600,000 = Ksh 5,400,000

Only the building of Ksh 5,400,000 will be depreciated.

6.1.8 Importance of correct cost determination

• Accurate depreciation: Depreciation is based on cost, so a wrong cost gives a wrong charge every year.
• Correct profit: Costs wrongly capitalised overstate profit, and those wrongly expensed understate it.
• Reliable statement of financial position: Asset values, and hence capital, depend on the cost recorded.
• Compliance with standards: Auditors check capitalised costs against IAS 16 or IPSAS 17 and may qualify accounts that do not follow them.
• Control of assets: Cost records in the asset register help trace, insure and verify assets.
• Basis for decisions: Managers compare the true cost of acquiring assets when planning purchases, replacements and budgets.