CHAPTER 5Fixed assets and depreciation

ContentsIntroductionSection 1 - General principles of asset valuationSection 2 Specific asset valuation problems

Contents (cont.)General principles of asset valuationExpensing assetsStraight-line depreciationDiminishing balance methodUnits of production methodTax depreciationComponents approachExcess depreciation as a hidden reserveAccounting for depreciationDisposal or retirement of a fixed asset

Contents (cont.)Specific asset valuation problemsIntangible fixed assetsResearch and developmentBrand namesPatentsPurchased goodwillTangible fixed assetsLand and buildingsPlant and equipmentLeased assetsInvestments

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:How do we determine tha appropriate value of an asset at the point of acquisition?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 assetThe 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 companys 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 valuationFixed assets are initially recorded at acquisition cost, which includes all expenditure to get the asset ready for useShould only include items reflecting economic benefits which extend over the current accounting periodCan include internal costsSubsequent expenditure is added to the cost only if it will produce economic benefits beyond its originally assessed performance

IAS 16 Elements of acquisition cost15.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 assetsFixed 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 problemAllocating the original cost of the asset over the period of its useDepreciation or amortization = the systematic expensing of the cost of an asset over the period which benefits from its use

Depreciation accountingDepreciable amount = acquisition cost minus the residual value of the assetThe depreciable amount is allocated on a systematic basis over its useful lifeThe depreciation method shall reflect the pattern in which the assets future economic benefits are expected to be consumed

Example Purchase of a van (1)Purchase of van (50,000) at the start of 20X1.EstimatesUse during 4 years, then sold at an estimated salvage value of 14,000 Uniform use pattern assumedAnnual 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)

Depreciation patternHas to be consistent through timeShould have a bearing on economic realityPhysical wear, technical or economic ageingVarious methods:Straight-line methodDiminishing balance methodUnits of production method

IAS 16 - Depreciation accounting50.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 assets 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 assets 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 periodSource: IAS 16 - Property, Plant and Equipment

Straight-line depreciationAssumes uniform consumption pattern of economic benefitsThe depreciation expense:

Diminished balance methodAllocates a high proportion of expense to the early years of the assets useful lifeDepreciation 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 ratewith:d= depreciation raten= number of accounting periodsR= residual valueA= acquisition cost

Impact of depreciation method on annual depreciation expenseAnnual depreciation expenseTimeStraight-lineDiminishing balance

Impact of depreciation method on book value of assetTime

Example diminishing value depreciationSuppose 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.

Tax depreciationTax rules can have a distorting effect on the application of depreciation rulesTax depreciation schedule and economic depreciation schedule may differ significantly

Example tax depreciation

Profit before

Annual

Profit after

Tax at 25%

depreciation

depreciation

depreciation

Tax method

Year 1

20,000

(12,000)

8,000

2,000

Year 2

20,000

(7,200)

12,800

3,200

Year 3

20,000

(800)

19,200

4,800

Year 4

20,000

-

20,000

5,000

Totals

80,000

(20,000)

60,000

15,000

Straight-line/economic

Year 1

20,000

(5,000)

15,000

3,750

Year 2

20,000

(5,000)

15,000

3,750

Year 3

20,000

(5,000)

15,000

3,750

Year 4

20,000

(5,000)

15,000

3,750

Totals

80,000

(20,000)

60,000

15,000

Units of production methodDepletion methodFixed asset is expensed according to physical capacity usage referentsEstimates of resource capacity and utilization are critical

Components approachFixed asset components with different useful lives or with different benefit consumption patterns should be recognised separatelyEach component will follow proper depreciation rulesSubsequent expenditure to replace or renew an asset component will be treated as the acquisition of a new asset

Depreciation accountsBalance sheet accounts: the net value of the asset (carrying amount or book value of the asset) is preserved through two accounts: Gross (acquisition) costAccumulated depreciationIncome statement account: Depreciation expense of the current yearBalances and details of these accounts are used in supplementary disclosures in the notes to the accounts

Disposal or retirement of a fixed assetDerecognition of a fixed asset occurs:On disposal, orWhen future economic benefits are no longer expectedAccounting effect of asset derecognition:Net book value of asset is eliminated in the balance sheetA gain or loss on disposal is recognised in the income statementGain or loss on disposal = difference between the net disposal proceeds and the net book value of the asset at disposal date

Specific asset valuation problemsIntangible fixed assetsResearch and developmentBrand namesPatentsPurchased goodwillTangible fixed assetsLand and buildingsPlant and equipmentLeased assetsInvestmentsInvestments

Main categories of non-current assetsTangible fixed assets (Property, plant and equipment) Intangible fixed assets (Intangibles)Investments (Long-term financial assets)

Intangible fixed assetsReflect 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 substanceMain characteristics:They meet the definition of an assetThey lack physical substanceThey are identifiable

IAS 38 Intangibles (cont.)Definition refers to identifiabilitySeparability, orArising from contractual or other legal rightsRecognition criteria challenge - Degree of uncertainty with respect to the future economic benefitsMagnitude and timing of future economic benefits?Control over economic benefitsThe useful life of an intangible asset can be finite or indefinite

Research and developmentIAS 38: distinction between the research and the development phaseResearch costs are always expensedDevelopment costs may qualify for asset recognitionSpecific recognition criteria for internally generated intangible assets specify when development costs should be recognised as an asset

Brand namesExpenditure on internally generated brands is in most cases indistinguishable from the cost of developing the business in generalA brand name acquired from another company will generally meet asset recognition criteriaBrand names can have an indefinite useful lifeIf indefinite useful life, no systematic amortization necessary

PatentsInternally generated patents:Application of specific recognition criteria for development costsIdentification of the related costs can be problematicDepreciation schedule can be a matter of debate

Purchased goodwillBuying customer goodwillControl over resources - issueUsually no legal rights to protect client relationshipsExchange transactions for the same or similar customer relationships may provide evidence that the company is able to control the expected future benefitsRecognition of internally generated goodwill as an asset is prohibited by IAS 38

Tangible fixed assetsIAS 16 Property, Plant and EquipmentAcquisition 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 managementSeparate values for land and buildings Land usually has an indefinite useful life and is therefore not depreciatedIn some cases acquisition cost will include capitalised decommissioning costsControl over fixed assets through ownership or lease agreement

Leased assetsIAS 17 LeasesA 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 timeFinance lease versus operating leaseFinance leaseSubstantially all risks and rewards of ownership of an asset are transferredLessee recognises the asset and a corresponding liabilityThe asset is initially measured at fair value and subsequently depreciated in the same way as legally owned assetsPeriodic lease payments include a principal component (to settle the liability) and an interest expense component

Ownership versus leaseBuilding (100,000) bought via bank loanAssets 100,000Liabilities 100,000Building leased over economic useful lifeAssets recognised at fair value (100,000)Liabilities recognised at fair value (100,000)Similar impact on P&L

InvestmentsNon-current financial assets Investments in not-controlled companiesEquity participations (shares)Long-term receivables / loansThey should reflect a strategic (long-term) relationship If no long-term relationship (only speculative purposes) they are classified as current assetsSpecific measurement rules (see chapter 12)

Straight-line depreciation = gelijkmatig in de tijd vast percentage van afschrijfbare AW

Reducing balance = degressieve methode = relatief hogere afschrijvingen in eerste jaren bijvoorbeeld: vast percentage van Boekwaarde - voor activa waarbij veel onzekerheid omtrent toekomstige gebruiksduur- voor activa met hoge onderhoudskost in latere gebruiksjaren- in vele gevallen fiscaal genspireerd fiscus laat methode toe om bepaalde investeringsimpulsen te geven.

Depletion: op basis van het fysische gebruik bijvoorbeeld de fysische uitputting van een mijn, oliebron=> In het voorbeeld van de bestelwagen zouden we jaarlijks kunnen afschrijven volgens aantal afgelegde km maar dit is eerder theorie dan praktijk !

Een conservatieve afschrijvingspolitiek kan een bron zijn van belangrijke verdoken reserves !!!!

Typically, there are 3 main categories of non-current (or fixed) assets

Non-current = useful life of more than 1 year.

They have different recognition and / or measurement rules.

Intangibles do not have physical substance, but they should meet the definition of an asset and the generic recognition criteria

What about publicity campaigns? R&D? Personnel training programs?Publicity campaigns: their aim is to increase future sales, but longer term effects are difficult to measure.Training programs: their aim is to improve future personnel performance, but their effect is difficult to control: if the employee quits, he will take his improved efficiency with him.

Definition of Intangibles: sharpened by the identifiability criterium, which is essential to distinguish intangibles from the more general concept of goodwill.Separable:capable of being separated from the company and sold, licensed, rented, etc.

Specific recognition criteria apply there should be future economic benefits, but one has to be sufficiently certain that they will accrue to the company in the future !Matching principle: additionally, it should be possible to arrive at a good / reliable estimate of the magnitude and timing of the future benefits (estimate of useful life?) to allow matching.

Some companies show a large R&D effort in order to detect and develop new or improved products which will improve future economic benefits. But R&D is a risky process with no guarantee that the efforts will lead to profitable products.

General principle: if uncertainty regarding magnitude and timing is too large => no matching of costs feasible and costs are to be taken immediately in the IS.Men gaat ervan uit dat economisch gezien er geen verschil is in substantie tussen beide transacties: beide geven aanleiding tot de capaciteit van nuttig gebruik van het geleaste goed over economische levensduur.

Er worden wel bepaalde voorwaarden gesteld aan het lease- contract voor activering:het contract moet betrekking hebben op het grootste deel van de economische levensduur,Moet toelaten het oorspronkelijk genvesteerde bedrag terug te betalen.

ZONIET : Operational lease !!

De tegenwaarde van de leaseschuld zal echter niet gelijk zijn aan de som van de periodieke leasebetalingen, daar de periodieke leasebetalingen ook een deel rente omvatten (net zoals we aan de bank periodiek de schuld aflossen + rente betalen)