1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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