Depreciation of property, plant and equipment Chapter 4 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Learning objectives (cont.) Understand when to start depreciating a depreciable asset Know the disclosure requirements of NZ IAS 16 ‘Property, Plant and Equipment’ as they pertain to depreciation Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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) (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Introduction (cont.) In determining how to allocate the cost of an asset, three issues must be addressed: Which depreciable base should be used for the asset? What is the asset’s useful life? Which method of cost apportionment is most appropriate for the asset? Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Depreciable amount (base) for assets 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 (NZ IAS 16) 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 (NZ IAS 16, par. 54) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Determination of useful life Useful life (NZ IAS 16) 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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Determination of useful life (cont.) Factors to consider (NZ IAS 16): 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 4.1, p. 179 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (NZ IAS 16) Available methods: Straight-line method Sum-of-digits method Declining-balance method Production basis Refer to Worked Example 4.2, p. 181 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Sum-of-digits method (cont.) 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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Revision of depreciation rate and method Residual value and useful life must be reviewed at least annually (NZ IAS 16) 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 (NZ IAS 16): Method to be changed where there is a significant change in pattern of benefits (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (NZ IAS 16) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Land and buildings Where acquired together, cost must be apportioned between land and buildings (NZ IAS 16) Buildings to be systematically depreciated over time Land not usually depreciated owing to unlimited useful life (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Land and buildings (cont.) Gain or loss from derecognition of asset Difference between net disposal proceeds and asset’s carrying amount (NZ IAS 16) Derecognition means (NZ IAS 16): Disposal of an asset; or When no future economic benefits are expected in respect of an asset Refer to Worked Example 4.3, p. 183 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Costs of modifying software for year 2000: Are to be expensed in the period incurred (Statement of Concepts) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Sale of a depreciable asset Profit or loss is calculated as the difference between: the carrying amount of an asset (cost or revalued amount less accumulated depreciation); and the amount received for the asset at fair value Refer to Worked Example 4.4, pp. 185–6 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Sale of a depreciable asset (cont.) Journal entries to record sale: Debit Cash at bank Credit Proceeds from sale Debit Carrying amount Debit Accumulated depreciation Credit Asset Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 NZ IAS 16 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Disclosure requirements For each class of property, plant and equipment the following must be disclosed (NZ IAS 16): 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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

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 as a revenue or expense Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider