1. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–1 Chapter 4 Depreciation of property, plant and equipment

2. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–2 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/ …

3. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–3 Learning 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  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–4 Status of newly converged accounting standards Prior to 2005, applicable standard was AASB 1021 ‘Depreciation’ From 2005, depreciation requirements are in AASB 116 ‘Property, Plant and Equipment’ Minimal differences between ‘old’ AASB 1021 and ‘new’ AASB 116 Amortisation of intangible assets is governed by AASB 136 ‘Intangible Assets’

5. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–5 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 Continues/ …

6. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–6 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, e.g. BHP and News Corp Continues/ …

7. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–7 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  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–8 Depreciable amount (base) for assets Depreciable amount – 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 equal to or greater than asset’s carrying amount, no depreciation is recognised (AASB 116, par. 54)

9. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–9 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 Continues/ …

10. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–10 Determination of useful life (cont.) Factors to consider (AASB 116): – 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

11. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–11 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 – production basis Refer to Worked Example 4.2

12. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–12 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  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–13 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 Continues/ …

14. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–14 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

15. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–15 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

16. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–16 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

17. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–17 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

18. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–18 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 Continues/ …

19. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–19 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 (AASB 116)

20. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–20 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 Continues/ …

21. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–21 Land and buildings (cont.) Gain or loss from derecognition of asset – Difference between net disposal proceeds and asset’s carrying amount (AASB 116) Derecognition means (AASB 116): – disposal of an asset; or – when no future economic benefits are expected in respect of an asset Refer to Worked Example 4.3

22. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–22 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/ …

23. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–23 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 (UIG Abstract 12)

24. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–24 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 Continues/ …

25. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–25 Sale of a depreciable asset (cont.) Journal entries to record sale: Debit Cash at bank Credit Proceeds from sale DebitCarrying amount DebitAccumulated depreciation CreditAsset

26. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–26 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 Continues/ …

27. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–27 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

28. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–28 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

29. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–29 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/ …

30. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 4–30 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