Transcript Document

CHAPTER 5
Fixed assets and depreciation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents



Introduction
Section 1 - General principles of asset
valuation
Section 2 – Specific asset valuation
problems
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents (cont.)

General principles of asset valuation





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

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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents (cont.)

Specific asset valuation problems

Intangible fixed assets





Tangible fixed assets




Research and development
Brand names
Patents
Purchased goodwill
Land and buildings
Plant and equipment
Leased assets
Investments
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© 2005 Peter Walton and Walter Aerts
Introduction – Fixed assets
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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
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Introduction – Fixed assets (cont.)

Two central accounting issues:
1.
2.

How do we determine tha appropriate value of
an asset at the point of acquisition?
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
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© 2005 Peter Walton and Walter Aerts
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.
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© 2005 Peter Walton and Walter Aerts
Asset valuation

Fixed assets are initially recorded at
acquisition cost, which includes all
expenditure to get the asset ready for use
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

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
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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.
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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
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© 2005 Peter Walton and Walter Aerts
Expensing fixed assets

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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
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Depreciation accounting
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
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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
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© 2005 Peter Walton and Walter Aerts
Example – Purchase of a van (1)
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Purchase of van (50,000) at the start of 20X1.
Estimates
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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
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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
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Depreciation pattern
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Has to be consistent through time
Should have a bearing on economic
reality
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Physical wear, technical or economic ageing
Various methods:
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

Straight-line method
Diminishing balance method
Units of production method
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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
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© 2005 Peter Walton and Walter Aerts
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.
Source: IAS 16 - Property, Plant and Equipment
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© 2005 Peter Walton and Walter Aerts
IAS 16 - Depreciation accounting
(cont.)
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.
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
IAS 16 - Depreciation accounting
(cont.)
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
Source: IAS 16 - Property, Plant and Equipment
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© 2005 Peter Walton and Walter Aerts
Straight-line depreciation
 Assumes uniform consumption pattern of
economic benefits
 The depreciation expense:
Depreciable amount
= Depreciation expense
Estimated useful life
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© 2005 Peter Walton and Walter Aerts
Diminished balance method
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
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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
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© 2005 Peter Walton and Walter Aerts
Diminishing balance depreciation rate
d=
1- n
R
A
with: d= depreciation rate
n= number of accounting periods
R= residual value
A= acquisition cost
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© 2005 Peter Walton and Walter Aerts
Impact of depreciation method on
annual depreciation expense
Annual
depreciation
expense
Diminishing
balance
Straight-line
Time
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© 2005 Peter Walton and Walter Aerts
Impact of depreciation method on
book value of asset
Straight-line versus Diminishing balance
Original book
value
Book value
Time
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© 2005 Peter Walton and Walter Aerts
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.
1
Net book value
start of year
€
1050
*45.6%
Depreciation
expense
€
= 479
2
571
*45.6%
= 260
Net book value
end of year
€
(1050 – 479 =) 571
(571 – 260 =) 311
3
311
*45.6%
= 142
(311 – 142 =) 169
4
169
*45.6%
= 77
(169 – 77 =) 92
5
92
*45.6%
= 42
(92 – 42 =) 50
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
Example tax depreciation
Profit before
depreciation
Annual
depreciation
Profit after
depreciation
Tax at 25%
8,000
12,800
19,200
20,000
2,000
3,200
4,800
5,000
(20,000)
60,000
15,000
Tax method
Year
Year
Year
Year
1
2
3
4
20,000
20,000
20,000
20,000
Totals
80,000
(12,000)
(7,200)
(800)
-
Straight-line/economic
Year
Year
Year
Year
1
2
3
4
20,000
20,000
20,000
20,000
(5,000)
(5,000)
(5,000)
(5,000)
15,000
15,000
15,000
15,000
3,750
3,750
3,750
3,750
Totals
80,000
(20,000)
60,000
15,000
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© 2005 Peter Walton and Walter Aerts
Units of production method
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

Depletion method
Fixed asset is expensed according to
physical capacity usage referents
Estimates of resource capacity and
utilization are critical
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
Depreciation accounts

Balance sheet accounts: the net value of the
asset (carrying amount or book value of the
asset) is preserved through two accounts:



Income statement account:


Gross (acquisition) cost
Accumulated depreciation
Depreciation expense of the current year
Balances and details of these accounts are
used in supplementary disclosures in the
notes to the accounts
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© 2005 Peter Walton and Walter Aerts
Disposal or retirement of a fixed
asset

Derecognition of a fixed asset occurs:



Accounting effect of asset derecognition:
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

On disposal, or
When future economic benefits are no longer expected
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
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© 2005 Peter Walton and Walter Aerts
Specific asset valuation problems

Intangible fixed assets





Tangible fixed assets





Research and development
Brand names
Patents
Purchased goodwill
Land and buildings
Plant and equipment
Leased assets
Investments
Investments
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© 2005 Peter Walton and Walter Aerts
Main categories of non-current
assets



Tangible fixed assets (Property, plant
and equipment)
Intangible fixed assets (Intangibles)
Investments (Long-term financial
assets)
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© 2005 Peter Walton and Walter Aerts
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
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IAS 38 - Intangibles


An intangible is an identifiable nonmonetary asset without physical
substance
Main characteristics:
 They
meet the definition of an asset
 They lack physical substance
 They are identifiable
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IAS 38 – Intangibles (cont.)

Definition refers to “identifiability”



Recognition criteria challenge - Degree of
uncertainty with respect to the future economic
benefits
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

Separability, or
Arising from contractual or other legal rights
Magnitude and timing of future economic benefits?
Control over economic benefits
The useful life of an intangible asset can be
finite or indefinite
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
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
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© 2005 Peter Walton and Walter Aerts
Tangible fixed assets

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
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
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© 2005 Peter Walton and Walter Aerts
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
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Ownership versus lease

Building (100,000) bought via bank loan
Assets 
Liabilities

Building leased over economic useful life
Assets 
Liabilities 

100,000
100,000
recognised at ‘fair value’ (100,000)
recognised at ‘fair value’ (100,000)
Similar impact on P&L
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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)
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© 2005 Peter Walton and Walter Aerts