Depreciation of property, plant and equipment Chapter 5 Depreciation of property, plant and equipment

Objectives of the lecture Understand the role of accounting in allocating the depreciable amount of a non-current asset over the asset’s expected useful life Be aware that the practice of calculating depreciation requires a number of decisions to be made including determining: The depreciable base The useful life Appropriate method of cost apportionment

Objectives of the lecture (cont.) 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 Understand when to start depreciating a depreciable asset Know how to account for the disposal of a depreciable asset Know the disclosure requirements of AASB 116 Property, Plant and Equipment as they pertain to depreciation

Relevant 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 fair 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 To allocate the cost of an asset three issues must be addressed Which depreciable base should be used? What is the asset’s useful life? 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 if this is substituted for cost) less its residual value Residual value The estimated amount that an entity would currently obtain from the disposal of an asset, after deducting the estimated costs of disposal, if the asset were already of the age and condition expected at the end of its useful life (AASB 116) Usually based on professional judgment Choice of residual value will influence future profits and assets If the residual value is equal to or greater than the 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: The period over which an asset is expected to be available for use by an entity; or - The number of production or similar units expected to be obtained from the asset by an entity Useful life is based on professional judgment Refer to Worked Example 5.2, p. 184—Determination of useful life

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 include: Straight-line method Sum-of-digits method Declining-balance method Units-of-production basis Refer to Worked Example 5.3, p. 185—A review of alternative depreciation methods

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 This would account 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) Depreciation method must also be reviewed annually (AASB 116) 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 Accounting Policies, Changes in Accounting Estimates and Errors

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 (with some exceptions, for example quarries and sites used for landfill)

Modifying existing non-current assets Accounting treatment when modifications or improvements are made to existing non-current assets Where expenditure is capitalised, the expenditure would subsequently be depreciated to the entity’s statement of comprehensive income Additions or extensions to an existing depreciable asset that becomes an integral part of that asset Addition or extension to an existing depreciable asset that retains a separate identity and will be capable of being used after that asset is disposed of

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) ‘Carrying amount’ is the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses Derecognition means (AASB 116): Disposal of an asset (perhaps through a sale); or When no future economic benefits are expected in respect of an asset

Sale of a depreciable asset The profit or loss on sale is generally referred to as a gain or loss on sale (or derecognition) Recognised on a ‘net basis’ in the statement of comprehensive income (that is, the proceeds from the sale are not separately shown as revenue) For example, the journal entries to record a sale of machinery for cash might be: Dr Cash at bank 300 Dr Accumulated depreciation—machinery 50 Cr Gain on sale of machinery 100 Cr Machinery 250 See Worked Example 5.6, p. 191—Disposal of a depreciable asset

What if the sale proceeds are deferred? When the receipt of the sale proceeds on the disposal of an item of property, plant and equipment is deferred for a period of time, AASB 116, paragraph 72, requires the fair value of the consideration to be recognised initially at its ‘cash price equivalent’.

What if the sale proceeds are deferred? (cont.) Specifically, AASB 116, paragraph 72 states: The consideration receivable on disposal of an item of property, plant and equipment is recognised initially at its fair value. If payment for the item is deferred, the consideration received is recognised initially at the cash price equivalent. The difference between the nominal amount of the consideration and the cash price equivalent is recognised as interest revenue in accordance with AASB 118 reflecting the effective yield on the receivable

What if the sale proceeds are deferred? (cont.) The discount rate to be used is the rate at which the vendor could invest the amount under similar terms and conditions See worked Example 5.7, p. 192—Sale proceeds deferred

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 the following cash-flow effects associated with the decision to comply/not comply with the requirement to depreciate buildings: non-compliance with depreciation requirement led to greater auditing costs benefits included cost savings associated with avoiding violation of debt contracts

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 process rather than a valuation process The depreciable base of an asset is its historical cost (or revalued amount) less any expected residual value and less any accumulated impairment losses 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 as a gain or a loss