5-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a australian financial accounting 5e by...

5-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig DeeganSlides prepared by Craig Deegan

Chapter 5

Depreciation of property, plant and equipment


Learning objectives

• Understand the role of accounting in allocating the depreciable amount of a non-current asset over the asset’s expected useful life

• Be aware of factors that must be considered in determining the useful life of a depreciable asset

• Understand the various approaches (straight-line, sum-of-digits, declining balance, production basis) for allocating the depreciable amount of a non-current asset to particular financial periods


Learning objectives (cont.)

• Understand when to start depreciating a depreciable asset

• Know the disclosure requirements of AASB 116 ‘Property, Plant and Equipment’ as they pertain to depreciation


Status of newly converged accounting standards

• Depreciation requirements for property, plant and equipment are contained in AASB 116 ‘Property, Plant and Equipment’

• Amortisation of intangible assets is governed by AASB 136 ‘Intangible Assets’


Introduction• Depreciation:

– recognises the decrease in the service potential of a non-current asset across time

– involves allocating the cost of an asset or revalued amount over periods in which benefits are expected to be derived

– involves recognising such allocation as an expense, unless included in another asset’s carrying amount

– should not be confused with the decline in market value of an asset over time


Introduction (cont.)• Depreciable assets

– non-current assets having limited useful lives

– depreciable assets may comprise a significant proportion of total assets

– depreciation expense can have a significant effect on profits, e.g. BHP and News Corp – so the selection of depreciation method can have significant implications for profits


Introduction (cont.)

• In determining how to allocate the cost of an asset three issues must be addressed1. Which depreciable base should be used for the asset?

2. What is the asset’s useful life?

3. Which method of cost apportionment is most appropriate for the asset?


Depreciable amount (base) for assets

• Depreciable amount (also referred to as depreciable base)– historical cost of a depreciable asset (or revalued

amount) less its residual value

• Residual value– the estimated amount expected to be obtained from

disposal of the asset at the end of its useful life less the estimated costs of disposal (AASB 116)

– usually based on professional judgment– choice of residual value impacts on future profits and

recorded assets– if equal to or greater than asset’s carrying amount, no

depreciation is recognised (AASB 116, par. 54)


Determination of useful life

Useful life (AASB 116)• An asset’s useful life

- is the period over which an asset is expected to be

available for use; or

- the number of production or similar units expected to be obtained from an asset

Useful life is based on professional judgment


Determination of useful life (cont.)

• Factors to consider (AASB 116)– wear and tear through physical use

– technical obsolescence (out of date as result of technological advances)

– commercial obsolescence (fall in market demand for goods and services produced by the asset)

– legal life, e.g. patents, licences, franchises and copyrights

• Refer to Worked Example 5.2 (p. 193)


Method of cost apportionment

• Should best reflect the economic reality of the asset’s use

• Must consider underlying physical, technical, commercial and/or legal facts (AASB 116)

• Available methods:– straight-line method

– sum-of-digits method

– declining-balance method

– production basis

• Refer to Worked Example 5.3 (p. 195)


Straight-line method

• Depreciation expense is calculated as

Cost Residual (salvage) value

Useful life

• This method is appropriate when benefits to be derived from the asset are expected to be uniform throughout the asset’s useful life


Sum-of-digits method

• (Cost less residual value) is multiplied by successively smaller fractions to calculate depreciation expense

• Numerator in fraction– changes each year, and is the years remaining of the asset’s

useful life at the beginning of the period

• Denominator in fraction– calculated by adding the years in the asset’s useful life; or– n(n +1)/2 where n is the useful life

• This method is appropriate when economic benefits expected to be derived are greater in the early years than later years


Declining-balance method

• Depreciation expense is calculated on the asset’s opening written-down value

• Written-down value– cost (or revalued amount) less accumulated

depreciation

• Percentage used for depreciation expense is calculated as 1 nth root of (residual value/cost)

• This method is appropriate when economic benefits expected to be derived are greater in the early years than in later years


Production basis

• Depreciation expense is calculated as:Units produced in current period x (cost residual value)

Total expected production

• This method is appropriate where useful life might be related more to production output than time


When to start depreciating an asset

• From the time an asset is first put into use, or is held ready for use

• If constructing an asset, it is not depreciated until ready for use

• If an asset is able to be used but is not actually used for a number of periods, the asset is still depreciated from the time it was able to be used– accounts for obsolescence rather than wear and tear


Revision of depreciation rate and method

• Residual value and useful life must be reviewed at least annually (AASB 116)

• If expected useful life or residual value are different from that previously expected:– entity must revise depreciation rate

• Depreciation method must also be reviewed annually (AASB 116):– method to be changed where there is a significant

change in pattern of benefits


Revision of depreciation rate and method (cont.)

• Revisions of depreciation rates can have significant effects on profits

• Any material changes in depreciation charges are to be disclosed as a change in accounting estimate in accordance with AASB 108


Land and buildings

• Where acquired together, cost must be apportioned between land and buildings (AASB 116)– buildings to be systematically depreciated over time

– land not usually depreciated owing to unlimited useful life


Derecognition of assets

• Gain or loss from derecognition of asset– difference between net disposal proceeds (measured at

fair value) and asset’s carrying amount (AASB 116)

• Derecognition means (AASB 116)– disposal of an asset; or

– when no future economic benefits are expected in respect of an asset


Sale of a depreciable asset (cont.)• The profit or loss on sale is generally referred to as a gain

or loss on derecognition

• Recognised on a ‘net basis’ in the income statement (that is, proceeds are not separately shown as revenue)

• Journal entries to record sale (if for cash)

Dr Cash at bank

Dr Accum. depreciation - asset

Cr Gain on derecognition of asset

Cr Asset


Illustration – Worked Example 5.5

• Sandon Point acquired an item of machinery on 1 July 2005 for a cost of $100,000

• When the asset was acquired it was considered that the asset would have a useful life to the entity of 5 years, after which time it would have no residual

• It was considered that the pattern of economic benefits would best be reflected by applying the sum of digits method

• Contrary to expectations, on 1 July 2007 the asset was sold for $70,000

• What was the profit on disposal and what are the journal entries to record the disposal?


Modifying existing non-current assets

• Expenditure on modifications or improvements should be capitalised where– expenditure is material; and

– expenditure is expected to enhance the service potential of the asset

• Expenditure is to be subsequently depreciated

• Additions or extensions that become an integral part of an existing asset:– are to be depreciated over the asset’s remaining life


Modifying existing non-current assets (cont.)

• Additions or extensions that retain a separate identity– are to be depreciated on the basis of their own useful

life


Contractual implications of building depreciation

• Recognition of building depreciation will increase expenses and decrease profits

• Likely to lead to unfavourable movements in accounting-based ratios

• Managers facing possible debt-covenant violations would be less inclined to want to comply with AASB 116


Contractual implications of building depreciation (cont.)

• Clinch (1983) found cash-flow effects associated with the decision to comply/not comply with the requirement to depreciate buildings, as follows– non-compliance with depreciation requirement led to

greater auditing costs

– benefits included cost savings associated with avoiding violation of debt contracts


Is allocating historical cost of an asset over its useful life really that appropriate?

• As we will learn in subsequent weeks, non-current assets such as plant and equipment, land, buildings can be carried at cost, or can be revalued to fair value

• If an asset is carried at cost, and that amount is depreciated over the expected useful life, whilst at the same time the organisation is paying out all profits in the form of dividends, then what happens if the cost to replace the asset has quadrupled across the life of the asset?

• Have profits tended to be overstated in ‘real terms’?• Have dividend payments tended to be excessive?


Disclosure requirements

• For each class of property, plant and equipment the following must be disclosed (AASB 116)– measurement basis used for gross carrying amount

– depreciation methods used

– useful lives or depreciation rates used

– gross carrying amount and accumulated depreciation at beginning and end of period

– reconciliation of carrying amount at beginning and end of period


Summary

• Depreciation is an allocation rather than a valuation process

• The depreciable base of an asset is its historical cost (or revalued amount) less any expected residual value

• Determination of useful life depends on judgments

• Depreciation method used should reflect pattern of benefits being derived from asset’s use


Summary (cont.)

• Available methods include: straight-line, sum-of digits, declining balance and production basis

• Depreciation starts from time when asset is put into use or is ready for use

• When an asset is sold the difference between the carrying amount and sales proceeds must be recognised a gain or a loss

5-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a australian financial accounting 5e by...

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