1

Accounting for tangible fixed Assets

• Fixed assets are used (not consumed) in operations of a business– provide benefits beyond the current accounting period

• Fixed assets are either acquired or self constructed– For self construction the rules for self construction of inventory apply

with regard to valuation (IAS 2), possibly borrowing costs are recognized

• Most relevant IFRS:IAS 16 – Property, Plant and Equipment

Definition according to IAS 16.6:Property, plant and equipment are tangible items that: (a) are held for use in the production or supply of goods or services, for

rental to others, or for administrative purposes; and(b) are expected to be used during more than one period.

2

Capitalization of property, plant and equipment

• IAS 16.7:The cost of an item of property, plant and equipment shall be

recognized as an asset if, and only if:(a) It is probable that future economic benefits associated with the

item will flow to the entity; and(b) The cost of the item can be measured reliably.

(general recognition rules for an asset apply)

• Valuation at initial recognition:– Historical Cost

• Historical Cost for specific examples:– Land

• historical cost includes purchase cost, legal fees, demolition costs of old structures etc.

– Buildings and equipment • historical cost includes all costs of acquisition and preparation for

use

3

Example: determining acquisition cost

• A firm purchases a new intranet that needs to get installed• The following costs are incurred:

– Catalogue list price € 10.000– Trade discount: 10%;

cash discount terms: 2/10, n/30 8.820– Freight cost including insurance 280 – Repair costs (unintentionally, a worker dropped a box) 400– Wires and other fixtures 500– Installation 500– Initial tests; consulting fees 450

Cost to be capitalized: € 10.950

4

Subsequent valuation

• Cost model: – asset is valued at historical cost less any accumulated depreciation and

any accumulated impairment losses

• Revaluation model: – an asset whose fair value can be measured reliably shall be measured

at its fair value at the date of the revaluation less any accumulated depreciation and any accumulated impairment losses

– Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period

– If an item is revalued, the entire class of assets shall be revalued (consistency principle)

An increase in value is recognized in “other comprehensive income”

5

Depreciation of tangible fixed assets

• Depreciation: The process of allocating the cost of tangible assets to the periods that benefit from these assets.

• Firm needs to determine– The useful life of an asset– The residual value of the asset at the end of its useful life

• If the residual value is material and can be measured reliably it reduces the depreciable amount

• The depreciable amount of an asset shall be allocated on a systematic basis over its useful life– The residual value and the useful life are to be reviewed at least at the

end of each financial year– Any changes in expectations are to be included prospectively

(according to IAS 8)

6

Depreciation continued

• Fixed assets are depreciated if their useful life is finite– this applies to buildings and equipment– It does not apply to land

• Depreciation is not for• valuation

– depreciation charges reflect that assets wear out (asset costs are charged to expense) but it does not reflect a decline in fair market value

– net book value = asset cost that has not yet been allocated as an expense

• replacement– cumulative depreciation as a provision for replacement– „internal financing“– Note, however, that financing is a matter of cash flows not of

bookkeeping!

7

Depreciation versus impairment

• Impairment is for valuation and reflects– loss in market value– loss in utility– estimation and measurement problems

Write-downs

Depreciation/Amortization Impairment

8

Asset Impairment

• Impairment carrying value higher than recoverable amount

Calculation of a possible impairment loss :

impairment loss = depreciated cost less

recoverable amount

Net selling price: fair value – cost of disposal

9

The useful life of assets

• determines depreciation period („depreciable life“) and depreciation charges

• is defined in terms of the time during which the asset is expected to be used by the company– The asset management policy may provide the disposal of assets after

a specified time or after consumption of a certain proportion of the economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter than its economic life.

• depreciable life:– a time period, e.g. ten years, or – an estimate for total production or usage, e.g. 70.000 units or 30.000

hours• physical deterioration and obsolescence limit useful life

10

Depreciation Methods

• most common methods:1. activity or usage method 2. straight-line method 3. sum-of-the-years‘-digits method 4. declining-balance method

Requirement: depreciation method employed must be • systematic (IAS 16.50)• Shall reflect the pattern in which the asset’s future economic

benefits are expected to be consumed by the entity (IAS 16.60)– The first requirement is fulfilled by all methods, the second is case

specific

11

1 - Activity or Usage Method

• if assets mainly wear out through use – it is „rational“ to depreciate on the basis of usage

• life of asset estimated in terms of output or input• advantage: low-output (input) periods generate low depreciation

charges

Year Units produced Depreciation charge ( € )

1 13.000 10.4002 15.000 12.0003 17.000 13.6004 11.000 8.8005 5.000 4.0006 8.000 6.4007 1.000 800

70.000 € 56.000

000.56000.70000.13400.10 Depreciation charge in year 1:

estimatione.g. based

on a product life

cycle

1212

2 – Straight-Line Method

• usability constant over time or no reasons for another pattern – rational to spread depreciable cost uniformly over the asset‘s life– fairly constant repair/maintenance cost

Income (after Rate ofYear Depreciation charge ( € ) Book value depreciation) return*

€ 80.000_1 10.000 70.000 5.000 6,67%2 10.000 60.000 5.000 7,69%3 10.000 50.000 5.000 9,09%4 10.000 40.000 5.000 11,11%5 10.000 30.000 5.000 14,29%6 10.000 20.000 5.000 20,00%7 10.000 10.000 5.000 33,33%

€ 70.000 residual value: € 10.000* income / average total assets

13

3 – Sum-of-the-Years‘-Digits Method

• decreasing charge method – „rational“ if asset has increasing repairs and maintenance

2)1(

nn

„sum of the years“ 282

562

)17(7

in the example:

Remaining Depreciation Depreciation Book valueYear Depreciation base ( € ) life in years fraction charge year-end

80.0001 70.000 7 7/28 17.500 62.5002 70.000 6 6/28 15.000 47.5003 70.000 5 5/28 12.500 35.0004 70.000 4 4/28 10.000 25.0005 70.000 3 3/28 7.500 17.5006 70.000 2 2/28 5.000 12.5007 70.000 1 1/28 2.500 10.000

28 28/28 € 70.000

14

4 – Declining-Balance Method

• (again a) declining charge method– constant percentage applied to a decreasing book value– no estimate of the useful life required, only a yearly depreciation rate

needed Rate on de- Depreciation Balance Accumu- Book value

Year Depreciation base ( € ) clining balance expense lated depreciation year-end

80.0001 80.000 26% 20.560 20.560 59.4402 59.440 26% 15.276 35.836 44.1643 44.164 26% 11.350 47.187 32.8134 32.813 26% 8.433 55.620 24.3805 24.380 26% 6.266 61.886 18.1146 18.114 26% 4.655 66.541 13.4597 13.459 26% 3.459 70.000 10.000

15

Determining the depreciation rate for given life and salvage value:

• with

– SV: salvage value– AC: acquisition cost– n: useful life, and – d: the depreciation rate

ACdSV n)1( nACSVd 1

16

Comparison of depreciation charges

• Purchase price: € 80.000; salvage value: € 10.000; useful life: 7 years

Depreciation charges under different methods

0

5.000

10.000

15.000

20.000

25.000

1 2 3 4 5 6 7

years

depr

ecia

tion

char

ge

straight-line sum-of-the-years declining balance activity

17

Depreciation for intra-period purchases and sales

• Depreciable life of an asset starts when the asset is available for use– This is typically not the beginning of the financial year

• Depreciation ceases at earlier of the date that the asset is classified as held for sale or derecognized (IAS 16.55)

• if asset is purchased or sold during the year depreciation charges need to be adjusted

• According to IFRS apportion of depreciation charges on a pro rata temporis basis is required

18

• Depreciation charges for office equipment

• purchased in February 2004• purchase price: € 84.000• the straight-line depreciation method used• useful life: 7 years• sold on 31st of May 2006 • fiscal year ends December 31

Example:

Year Annual DepreciationRate

DepreciationPeriod

Depreciation Charge

2004 12,000 11/12 11,0002005 12,000 12/12 12,0002006 12,000 5/12 5,000

19

Revisions of Depreciation Rates

• useful life is only an estimate, subject to change• depreciable amount can change (see next slide)• changes are handled in current and prospective periods, no revision

of earlier periods!

• Example change in useful life: asset with depreciation base of € 10.000 and useful life of 5 years; in year four, useful life is reestimated to be 8 years overall.

2.0005

10.000 800

3-86.000-10.000

„initial“ charges: revised charges:

Year 1 2 3 4 5 6 7 8 Total

Depreciation charge 2.000 2.000 2.000 800 800 800 800 800 10.000

20

Revisions of Depreciation Base

• Postacquisition expenditures: betterments or maintenance?– repair and maintenance cost: necessary to maintain asset– betterments – costs incurred to improve the asset

• What characterizes a betterment (capital improvement)?– Increase the asset‘s useful life– Improve the quality of the asset‘s output– Increase the quantity of the asset‘s output– Reduce the costs associated with operating the asset– material amount of investment relative to acquisition cost

Improvements are capitalized.

21

Revision of depreciation method

• Accelerated method is replaced by straight line method at the time when the accelerated book value would exceed the one resulting from the straight line method applied to the rest of the useful life.

• Example: AC = 100; n = 10; SV = 0; d = 20%.

depreciation straight line reviseddec. Balance depreciation depreciation

20,00 10,00 20,0016,00 8,89 16,0012,80 8,00 12,8010,24 7,31 10,248,19 6,83 8,196,55 6,55 6,555,24 6,55 6,553,93 6,55 6,552,62 6,56 6,561,31 6,56 6,560,00

100,01

22

Gains and losses on sales of tangible assets

• not every asset is held until the end of its useful life• sales price different from current book value: gain/loss from sales

results• Example : computer that has a useful life of three years is sold after

two years for a price of € 1.000; original cost was € 2.100.

Journal entry:

Income statement presentation:

in most cases, gains/lossesincluded in „other income“

Sales price 1.000Less book value Cost 2.100 Accumulated depreciation 1.400 700 Gain 300

Cash 1.000Accumulated depreciation 1.400

Computer equipment 2.100Gain on sale of equipment 300