CHAPTER 5 Fixed 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 41,0009,000 End 20x2 32,0009,000 End 20x3 23,0009,000 End 20x4 14,0009,000

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. Source: IAS 16 - Property, Plant and Equipment

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.

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

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 A R d= 1- with:d= depreciation rate n= number of accounting periods R= residual value A= 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 €€ € 11050*45.6%= 479 (1050 – 479 =) *45.6%= 260 (571 – 260 =) *45.6%= 142 (311 – 142 =) *45.6%= 77 (169 – 77 =) *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

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 loan Assets  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)