1. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-1 Chapter 5 Depreciation of property, plant and equipment

2. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-2 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 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

3. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-3 Objectives (cont.) Understand when to start depreciating a depreciable asset Know the disclosure requirements of AASB 116 Property, Plant and Equipment as they pertain to depreciation

4. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-4 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

5. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-5 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

6. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-6 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, so the selection of depreciation method can have significant implications for profits

7. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-7 Introduction (cont.) In determining how to allocate the cost of an asset three issues must be addressed 1.Which depreciable base should be used for the asset? 2.What is the asset’s useful life? 3.Which method of cost apportionment is most appropriate for the asset?

8. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-8 Depreciable amount (base) for assets Depreciable amount (also referred to as depreciable base) –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 (AASB 116) –Usually based on professional judgment –Choice of residual value impacts on future profits and recorded assets –If the residual value is equal to or greater than the asset’s carrying amount, no depreciation is recognised (AASB 116, par. 54)

9. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-9 Determination of useful life Useful life (AASB 116) 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

10. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-10 Determination of useful life (cont.) Factors to consider (AASB 116) –Wear and tear through physical use –Technical obsolescence (out of date as a 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 5.2 (p. 178)— Determination of useful life

11. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-11 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 –straight-line method –sum-of-digits method –declining-balance method –units-of-production basis Refer to Worked Example 5.3 (p. 179)—A review of alternative depreciation methods

12. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-12 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

13. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-13 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 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

14. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-14 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  n th 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

15. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-15 Production basis Depreciation expense is calculated as: U nits 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

16. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-16 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

17. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-17 Revision of depreciation rate and method Residual value and useful life must be reviewed at least annually (AASB 116) 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 (AASB 116): –method to be changed where there is a significant change in pattern of benefits

18. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-18 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 as a change in accounting estimate in accordance with AASB 108

19. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-19 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

20. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-20 Modifying existing non-current assets When modifications or improvements are made to existing non- current assets and the expenditure is material and considered to enhance the service potential of the asset, such expenditure should be capitalised to the extent that particular accounting standards do not preclude such capitalisation (e.g. AASB 138 prohibits the capitalisation of expenditures on certain types of intangible assets) Where expenditure is capitalised, the expenditure would subsequently be depreciated to the entity’s statement of comprehensive income The depreciable amount of any addition or extension to an existing depreciable asset that becomes an integral part of that asset must be allocated over the remaining useful life of that asset The depreciable amount of any 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 must be allocated independently of the existing asset, and on the basis of its own useful life

21. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-21 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) 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

22. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-22 Sale of a depreciable asset The profit or loss on sale is generally referred to as a gain or loss on sale (or de-recognition) 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 DrAccumulated depreciation—Machinery CrGain on sale of machinery CrMachinery

23. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-23 Illustration—Worked Example 5.5 Sandon Point acquired an item of machinery on 1 July 2008 for a cost of $100 000 When the asset was acquired it was considered that the asset would have a useful life to the entity of five years, after which time it would have no residual value It was considered that the pattern of economic benefits would best be reflected by applying the sum of digits method Contrary to expectations, on 1 July 2010 the asset was sold for $70 000 What was the profit on disposal and what are the journal entries to record the disposal?

24. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-24 Illustration—Solution For an asset with a useful life of five years the sum-of-digits depreciation is: n(n + 1) ÷ 2 = 5 × 6 ÷ 2 = 15 –First year depreciation = 5 ÷ 15 × $100 000 = $33 333 –Second year depreciation = 4 ÷ 15 × $100 000 = $26 667 Total accumulated depreciation at 1 July 2010 = $60 000 Therefore the carrying amount of the asset is $40 000, made up of the historical cost of $100 000 less the accumulated depreciation of $60 000 The accounting entry would be: Dr Cash at bank 70 000 Dr Accumulated depreciation—machinery 60 000 Cr Gain on sale of machinery 30 000 Cr Machinery 100 000

25. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-25 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’. Specifically, 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 The discount rate to be used is the rate at which the vendor could invest the amount under similar terms and conditions

26. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-26 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

27. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-27 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

28. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-28 Is allocating historical cost of an asset over its useful life really that appropriate? As we will learn in subsequent weeks, non-current assets such as plant and equipment, land, and buildings can be carried at cost, or can be revalued to fair value If an asset is carried at cost, and that amount is depreciated over the expected useful life, while at the same time the organisation is paying out all profits in the form of dividends, what happens if the cost to replace the asset has quadrupled across the life of the asset? Have profits tended to be overstated in ‘real terms’? Have dividend payments tended to be excessive?

29. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-29 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

30. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-30 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 Determination of useful life depends on judgments Depreciation method used should reflect pattern of benefits being derived from asset’s use

31. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5-31 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