chapter 5 fixed assets and depreciation. contents introduction section 1 - general principles of...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 5Fixed assets and

depreciation


Contents

Introduction Section 1 - General principles of

asset valuation Section 2 – Specific asset valuation

problems


Contents (cont.) General principles of asset valuation

Expensing assets Straight-line depreciation Diminishing balance method Units of production method Tax depreciation Components approach Excess depreciation as a hidden reserve Accounting for depreciation Disposal or retirement of a fixed asset


Contents (cont.) Specific asset valuation problems

Intangible fixed assets Research and development Brand names Patents Purchased goodwill

Tangible fixed assets Land and buildings Plant and equipment Leased assets

Investments


Introduction – Fixed assets Fixed assets (non-current assets)

represent future economic benefits which are expected to be consumed at a slow pace (generaly over more than one financial year)

Every fixed asset can be considered an unexpired expense, and at balance sheet date a company must review to what extent the individual asset has been consumed during the accounting period


Introduction – Fixed assets (cont.)

Two central accounting issues:1. How do we determine tha appropriate value

of an asset at the point of acquisition?2. How do we systematically recognise the

expensing of the asset over time? IAS 16 Property, Plant and Equipment

addresses these questions in general and more specifically for tangible fixed assets


IASB Framework – Recognition of an asset

The IASB Framework says that an asset should be recognized if

(a) it is probable that a future economic benefit associated with the element will flow to the entity, and

(b) the item has a cost or value that can be measured reliably.

Applied to a van, this means that, provided that the van is useful in the company’s operations, and its purchase value is certain, it should be treated as an asset. As the van is used, the amount of future economic benefits is decreasing.


Asset valuation Fixed assets are initially recorded at

acquisition cost, which includes all expenditure to get the asset ready for use Should only include items reflecting economic

benefits which extend over the current accounting period

Can include internal costs Subsequent expenditure is added to the

cost only if it will produce economic benefits beyond its originally assessed performance


IAS 16 – Elements of acquisition cost

15. An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost.

16. The cost of an item of property, plant and equipment comprises:(a)its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b)any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.


IAS 16 – Elements of acquisition cost (cont.)

17. Examples of directly attributable costs are:(a)costs of employee benefits arising directly from the construction or acquisition of the item of property, plant and equipment;(b) costs of site preparation;(c) initial delivery and handling costs;(d) installation and assembly costs;(e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and(f) professional fees.

Source: IAS 16 - Property, Plant and Equipment


Expensing fixed assets Fixed assets generally have a finite life – as

they age (technically, commercially), their acquisition cost will be expensed in order to match with the revenues produced by using them (consumption of future economic benefits)

This is a typical allocation problem Allocating the original cost of the asset over the

period of its use Depreciation or amortization = the

systematic expensing of the cost of an asset over the period which benefits from its use


Depreciation accounting

Depreciable amount = acquisition cost minus the residual value of the asset

The depreciable amount is allocated on a systematic basis over its useful life

The depreciation method shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed


Example – Purchase of a van (1)

Purchase of van (50,000) at the start of 20X1. Estimates

Use during 4 years, then sold at an estimated salvage value of 14,000

Uniform use pattern assumed Annual depreciation expense =

= (acquisition cost – salvage value) / number of periods

= (50,000 – 14,000) / 4 year= 9,000 a year


Example – Purchase of a van (2)

Balance sheet date

Book value of asset

Depreciation expense in IS

Purchase 50,000 -

End 20x1 41,000 9,000

End 20x2 32,000 9,000

End 20x3 23,000 9,000

End 20x4 14,000 9,000


Depreciation pattern

Has to be consistent through time Should have a bearing on

economic reality Physical wear, technical or economic ageing

Various methods: Straight-line method Diminishing balance method Units of production method


IAS 16 - Depreciation accounting

50. The depreciable amount of an asset shall be allocated on a systematic basis over its useful life.

53. The depreciable amount of an asset is determined after deducting its residual value. In practice, the residual value of an asset is often insignificant and therefore immaterial in the calculation of the depreciable amount.

56. The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economics benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset:

continues


IAS 16 - Depreciation accounting (cont.)

56. (a) expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output.(b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle.(c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset.(d) legal or similar limits on the use of the asset, such as the expiry dates of related leases.




60. The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

61. The depreciation method applied to an asset shall be reviewed at least at each financial year-end, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method shall be changed to reflect the changed pattern.



73. The financial statements shall disclose, for each class of property, plant and equipment:(a) the measurement bases used for determining the gross carrying amount;(b) the depreciation methods used;(c) the useful lives or the depreciation rates used;(d) the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period



Straight-line depreciation

Depreciable amount

Estimated useful life

= Depreciation expense

Assumes uniform consumption pattern of economic benefits

The depreciation expense:


Diminished balance method

Allocates a high proportion of expense to the early years of the asset’s useful life

Depreciation expense is calculated as percentage of the asset value after deduction of previous years’ accumulated depreciation (‘the balance of the asset’)

Depreciation rate can be mathematically derived, but will usually be approximated


Diminishing balance depreciation rate

n

ARd=

1-

with: d= depreciation raten= number of accounting periodsR= residual valueA= acquisition cost


Impact of depreciation method on annual depreciation expense

Annual depreciation expense

Time

Straight-line

Diminishing balance


Impact of depreciation method on book value of asset

Original book value

Book value

Straight-line versus Diminishing balance

Time


Example diminishing value depreciation

Suppose that an asset was acquired for €1,050 with an expected useful life of five years and a scrap value of €50. The annual rate would be 45.6 per cent.

Net book value start

of year

Depreciation

expense

Net book value end of year

€ € €

1 1050 *45.6% = 479(1050 – 479 =)

5712 571 *45.6% = 260 (571 – 260 =) 3113 311 *45.6% = 142 (311 – 142 =) 1694 169 *45.6% = 77 (169 – 77 =) 925 92 *45.6% = 42 (92 – 42 =) 50


Tax depreciation

Tax rules can have a distorting effect on the application of depreciation rules

Tax depreciation schedule and economic depreciation schedule may differ significantly


Example tax depreciation Profit before Annual Profit after Tax at 25% depreciation depreciation depreciation Tax method

Year 1 20,000 (12,000) 8,000 2,000 Year 2 20,000 (7,200) 12,800 3,200 Year 3 20,000 (800) 19,200 4,800 Year 4 20,000 - 20,000 5,000

Totals 80,000 (20,000) 60,000 15,000

Straight-line/economic

Year 1 20,000 (5,000) 15,000 3,750 Year 2 20,000 (5,000) 15,000 3,750 Year 3 20,000 (5,000) 15,000 3,750 Year 4 20,000 (5,000) 15,000 3,750

Totals 80,000 (20,000) 60,000 15,000


Units of production method

Depletion method Fixed asset is expensed according

to physical capacity usage referents

Estimates of resource capacity and utilization are critical


Components approach

Fixed asset components with different useful lives or with different benefit consumption patterns should be recognised separately

Each component will follow proper depreciation rules

Subsequent expenditure to replace or renew an asset component will be treated as the acquisition of a new asset


Depreciation accounts Balance sheet accounts: the net value of

the asset (carrying amount or book value of the asset) is preserved through two accounts: Gross (acquisition) cost Accumulated depreciation

Income statement account: Depreciation expense of the current year

Balances and details of these accounts are used in supplementary disclosures in the notes to the accounts


Disposal or retirement of a fixed asset

Derecognition of a fixed asset occurs: On disposal, or When future economic benefits are no longer

expected Accounting effect of asset derecognition:

Net book value of asset is eliminated in the balance sheet

A gain or loss on disposal is recognised in the income statement

Gain or loss on disposal = difference between the net disposal proceeds and the net book value of the asset at disposal date


Specific asset valuation problems

Intangible fixed assets Research and development Brand names Patents Purchased goodwill

Tangible fixed assets Land and buildings Plant and equipment Leased assets Investments

Investments


Main categories of non-current assets

Tangible fixed assets (Property, plant and equipment)

Intangible fixed assets (Intangibles) Investments (Long-term financial

assets)


Intangible fixed assets Reflect intangible resources such as

scientific and technical knowledge, development of new processes or systems, intellectual property, privileged customer relationships, etc.

Typical examples: R&D, brand names, copyrights, computer software, licences, patents


IAS 38 - Intangibles

An intangible is an identifiable non-monetary asset without physical substance

Main characteristics: They meet the definition of an asset They lack physical substance They are identifiable


IAS 38 – Intangibles (cont.)

Definition refers to “identifiability” Separability, or Arising from contractual or other legal rights

Recognition criteria challenge - Degree of uncertainty with respect to the future economic benefits Magnitude and timing of future economic

benefits? Control over economic benefits

The useful life of an intangible asset can be finite or indefinite


Research and development IAS 38: distinction between the research

and the development phase Research costs are always expensed Development costs may qualify for asset

recognition Specific recognition criteria for

internally generated intangible assets specify when development costs should be recognised as an asset


Brand names Expenditure on internally generated

brands is in most cases indistinguishable from the cost of developing the business in general

A brand name acquired from another company will generally meet asset recognition criteria

Brand names can have an indefinite useful life If indefinite useful life, no systematic

amortization necessary


Patents

Internally generated patents: Application of specific recognition

criteria for development costs Identification of the related costs can

be problematic Depreciation schedule can be a

matter of debate


Purchased goodwill Buying ‘customer goodwill’ ‘Control over resources’ - issue

Usually no legal rights to protect client relationships

Exchange transactions for the same or similar customer relationships may provide evidence that the company is able to control the expected future benefits

Recognition of internally generated goodwill as an asset is prohibited by IAS 38


Tangible fixed assets IAS 16 Property, Plant and Equipment Acquisition cost = purchase price +ancillary costs

to bring the asset to the location and condition necessary for it to be capable of operating in the manner intended by management

Separate values for land and buildings Land usually has an indefinite useful life and is

therefore not depreciated In some cases acquisition cost will include

capitalised decommissioning costs Control over fixed assets through ownership or

lease agreement


Leased assets IAS 17 Leases

A lease is an arrangement whereby the lessor conveys to the lessee in return for a series of payments the right to use an asset for an agreed period of time

Finance lease versus operating lease Finance lease

Substantially all risks and rewards of ownership of an asset are transferred

Lessee recognises the asset and a corresponding liability The asset is initially measured at fair value and

subsequently depreciated in the same way as legally owned assets

Periodic lease payments include a principal component (to settle the liability) and an interest expense component


Ownership versus lease

Building (100,000) bought via bank loanAssets 100,000

Liabilities 100,000 Building leased over economic useful life

Assets recognised at ‘fair value’ (100,000)

Liabilities recognised at ‘fair value’ (100,000)

Similar impact on P&L


Investments

Non-current financial assets Investments in not-controlled companies

Equity participations (shares) Long-term receivables / loans

They should reflect a strategic (long-term) relationship

If no long-term relationship (only speculative purposes) they are classified as current assets

Specific measurement rules (see chapter 12)

chapter 5 fixed assets and depreciation. contents introduction section 1 - general principles of...

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