Week 2- Chapters 5 & 6

Week 2- Chapters 5 & 6 Chp 5: Depreciation of property, plant and equipment

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 that the practice of calculating depreciation requires a number of decisions to be made including determining: • The depreciable base • The useful life • Appropriate method of cost apportionment

Objectives of the lecture (cont.) • Understand the various approaches (straight line, sum-of-digits, declining or reducing balance, production basis) for allocating the depreciable amount of a non-current asset to particular financial periods • Understand when to start depreciating a depreciable asset • Know how to account for the disposal of a depreciable asset • Know the disclosure requirements of AASB 116 Property, Plant and Equipment as they pertain to depreciation

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

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 fair value of an asset over time

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 • To allocate the cost of an asset three issues must be addressed • Which depreciable base should be used? • What is the asset’s useful life? • Which method of cost apportionment is most appropriate for the asset?

Depreciable amount (base) for assets • Depreciable amount (also referred to as depreciable base) • Historical cost of a depreciable asset (or revalued amount if this is substituted for cost) less its residual value • Residual value • The estimated amount that an entity would currently obtain from the disposal of an asset, after deducting the estimated costs of disposal, if the asset were already of the age and condition expected at the end of its useful life (AASB 116) • Usually based on professional judgment • Choice of residual value will influence future profits and assets • If the residual value is equal to or greater than the asset’s carrying amount, no depreciation is recognised (AASB 116, par. 54)

Determination of useful life Useful life (AASB 116) • An asset’s useful life: • The period over which an asset is expected to be available for use by an entity; or - The number of production or similar units expected to be obtained from the asset by an entity • Useful life is based on professional judgment Refer to Worked Example 5.2, p. 184—Determination of useful life

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 include: • Straight-line method • Sum-of-digits method • Declining (or reducing)-balance method • Units-of-production basis Refer to Worked Example 5.3, p. 185—A review of alternative depreciation methods

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 • This would account for obsolescence rather than wear and tear

Revision of depreciation rate and method • Residual value and useful life must be reviewed at least annually (AASB 116) • Depreciation method must also be reviewed annually (AASB 116) • 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 Accounting Policies, Changes in Accounting Estimates and Errors

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 (with some exceptions, for example quarries and sites used for landfill)

Modifying existing non-current assets • Accounting treatment when modifications or improvements are made to existing non-current assets • Where expenditure is capitalised, the expenditure would subsequently be depreciated to the entity’s statement of comprehensive income • Additions or extensions to an existing depreciable asset that becomes an integral part of that asset • 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

Sale of a depreciable asset • The profit or loss on sale is generally referred to as a gain or loss on sale (or derecognition) • 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 300 Dr Accumulated depreciation—machinery 50 Cr Gain on sale of machinery 100 Cr Machinery 250 See Worked Example 5.6, p. 191—Disposal of a depreciable asset

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 and less any accumulated impairment losses • Determination of useful life depends on judgments • Depreciation method used should reflect pattern of benefits being derived from asset’s use

Summary (cont.) • Available methods include: straight line, sum-of digits, declining or reducing 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

Chp 6: Revaluations and impairment of non-current assets

Objectives of this lecture • Understand the meaning of fair value • Understand how and when to revalue an item of property, plant and equipment in accordance with AASB 116 • Understand how and when to revalue an intangible asset in accordance with AASB 138 • Understand the difference in accounting treatments for upward revaluations to ‘fair value’, as opposed to write-downs to ‘recoverable amount’ • Understand what an ‘impairment loss’ is and know how to account for one

Objectives (cont.) • Understand how to account for revaluations that act to reverse previous revaluation increments and decrements • Understand how to account for accumulated depreciation when a non-current depreciable asset is revalued • Understand that, subsequent to revaluation, new depreciation charges will be based on the revalued amount of the non-current asset • Know how the profit is determined on disposal of a revalued non-current asset

Objectives (cont.) • Understand how asset revaluations can affect an organisation’s profits owing to changes in depreciation expenses and in final profits or losses on the sale of the revalued asset • Be able to explain possible motivations driving an organisation to elect to revalue, or not to revalue, its non-current assets to fair value • Know the disclosure requirements pertaining to asset revaluations

Relevant accounting standards There are three standards of particular relevance • AASB 116 Property, Plant and Equipment Requirements for revaluations, depreciation and determining acquisition cost of property, plant and equipment • AASB 138 Intangible Assets Revaluation of intangible assets and other issues 3.AASB 136 Impairment of Assets When to recognise an ‘impairment loss’

Introduction to revaluations • Historical cost has been criticised for bearing no relation to current asset values • In Australia, entities may revalue many non-current assets • However, AASB 138 specifically excludes the revaluation of some intangible assets • Asset revaluations—what are they? • Recognising a reassessment of the carrying amount of a non-current asset to fair value as at a particular date • Excludes recoverable amount write-downs (i.e. impairment losses)

Introduction to impairment losses • If a non-current asset’s carrying amount exceeds its recoverable amount it must be written down to its recoverable amount (AASB 136) • Impairment losses can be reversed in subsequent periods (unless a particular accounting standard prohibits it—as is the case with intangible assets)

Impairment losses • Keys terms include: • impairment loss • carrying amount • recoverable amount • fair value, less costs of disposal (or net selling price) • value in use • Worked Example 6.1, p. 205 provides an example of a reversal of an impairment loss

Measuring property, plant and equipment at cost or fair value—the choice • AASB 116 requires each class of property, plant and equipment to be measured at either cost or fair value • Entities may switch from fair value to cost for justifiable reasons and provided adequate disclosures are made (AASB 116) • If a class of non-current assets is measured at cost, AASB 136 is to be applied (slide 6-7)

The use of fair values • Any revaluation of non-current assets must be to fair value (AASB 116) • Fair value is determined on the assumption that the entity is a going concern • The required disclosures regarding asset revaluations (AASB 116) are: • effective date of revaluation • whether an independent valuer was involved • methods and significant assumptions applied • extent to which fair values were determined • for each revalued class, the carrying amount if the cost model was used • the revaluation surplus

The use of fair values (cont.) • Revaluations must be made with sufficient regularity so the carrying amount of each asset in the class does not differ materially from its fair value (AASB 116) • If values change regularly and changes are material, revaluations might be necessary each reporting period • Otherwise every three to five years is sufficient

Revaluation increments • General procedure (AASB 116) Debit Asset Credit Revaluation surplus (70%) Deferred Tax Liability (30%) • The revaluation surplus is part of shareholders’ funds (owners’ equity)

Treatment of balances of accumulated depreciation upon revaluation • If a revalued asset is a depreciable asset, any balance of accumulated depreciation is credited to the asset account prior to revaluation (AASB 116) • Journal entry (net-amount method) Dr Accumulated depreciation—machine Cr Machine Dr Machine Cr Revaluation surplus DTL • Subsequent depreciation is to be based on the revalued amount of the asset Refer to Worked Example 6.5, pp. 211—Revaluation of a depreciable asset using the net-amount method

Revaluation decrements • In line with the concept of conservatism, revaluation decrements are recognised as an expense within profit or loss in the statement of comprehensive income • Contrast this with a revaluation increment wherein the increase in the revaluation surplus is included in ‘other comprehensive income’ • Journal entry (AASB 116) Dr Accumulated depreciation Cr Asset Dr Loss on revaluation of asset Cr Asset Refer to Worked Example 6.7 (p. 213)—A revaluation decrement

Reversal of revaluation decrements and increments • For an asset class, reversals of previous revaluations should be recorded by the reverse of the initial revaluation entries

Reversal of revaluation decrements and increments • If a revaluation decrement reverses a previous increment for the same asset, then the entries are: Dr Accumulated depreciation Cr Asset Dr Revaluation surplus DTL Loss on revaluation (the excess, if any) Cr Asset Refer to Worked Example 6.8, p.214—Reversal of previous revaluation increments and decrements

Accounting for the gain or loss on disposal of a revalued non-current asset • Derecognition is: • the point in time when an asset is removed from the statement of financial position (balance sheet) • when an asset is sold, or • when no future economic benefits are expected from an asset’s use or disposal • Gain or loss from derecognition of an item of property, plant and equipment is to be calculated as the difference between (AASB 116): • net disposal proceeds (if any), and • the asset’s carrying amount

Accounting for profit on disposal of a revalued non-current asset • When an asset is sold, any resulting balance in the revaluation surplus (AASB 116): • may be transferred directly to retained earnings • cannot be transferred to the profit or loss • If a non-current asset is revalued upwards, any gain on sale will be less than the gain if the asset had not previously been revalued Refer to Worked Examples 6.9, 6.10 and 6.11, pp. 216–218

Summary • This lecture considered the revaluation of non-current assets, with the emphasis on property, plant and equipment • If the recoverable amount is below the carrying amount, an impairment loss should be recorded • For upwards revaluations: • assets are to be revalued to fair value • any increase is to be transferred to a revaluation surplus, unless it is a reversal

Summary (cont.) • For downwards revaluations: • any decrease is to be treated as an expense, unless it is a reversal • When a revaluation is undertaken: • any existing accumulated depreciation should be credited against the non-current asset (if the net method is used—which is the common approach), and • the non-current asset should be increased by the amount of the revaluation • Where a revalued asset is sold, the gain or loss is the difference between the carrying amount and the net disposal proceeds of the asset

Week 2- Chapters 5 & 6