CHAPTER 5

Fixed assets and depreciation

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© 2005 Peter Walton and Walter Aerts
 Contents
 Introduction
 Section 1 - General principles of asset
valuation
 Section 2 – Specific asset valuation
problems

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 Contents (cont.)
 General principles of asset valuation
 Expensing assets
 Straight-line depreciation
 Diminishing balance method
 Units of production method
 Tax depreciation
 Components approach
 Excess depreciation as a hidden reserve
 Accounting for depreciation
 Disposal or retirement of a fixed asset

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 Contents (cont.)
 Specific asset valuation problems
 Intangible fixed assets
 Research and development
 Brand names
 Patents
 Purchased goodwill
 Tangible fixed assets
 Land and buildings
 Plant and equipment
 Leased assets
 Investments

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 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

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 Introduction – Fixed assets (cont.)
 Two central accounting issues:
1. How do we determine tha appropriate value of
an asset at the point of acquisition?
2. 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

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 IASB Framework –
Recognition of an asset
The 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 company’s 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.

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 Asset valuation
 Fixed assets are initially recorded at
acquisition cost, which includes all
expenditure to get the asset ready for use
 Should only include items reflecting economic
benefits which extend over the current accounting
period
 Can include internal costs
 Subsequent expenditure is added to the cost
only if it will produce economic benefits
beyond its originally assessed performance

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 IAS 16 – Elements of acquisition cost

15.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.

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 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

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 Expensing fixed assets
 Fixed 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 problem
 Allocating the original cost of the asset over the
period of its use
 Depreciation or amortization = the systematic
expensing of the cost of an asset over the
period which benefits from its use

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 Depreciation accounting
 Depreciable amount = acquisition cost
minus the residual value of the asset
 The depreciable amount is allocated on a
systematic basis over its useful life
 The depreciation method shall reflect the
pattern in which the asset’s future economic
benefits are expected to be consumed

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 Example – Purchase of a van (1)
 Purchase of van (50,000) at the start of 20X1.
 Estimates
 Use during 4 years, then sold at an estimated salvage
value of 14,000
 Uniform use pattern assumed
 Annual depreciation expense =
= (acquisition cost – salvage value) / number of periods
= (50,000 – 14,000) / 4 year
= 9,000 a year

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 Example – Purchase of a van (2)

Balance sheet Book value of asset Depreciation

date expense in IS
Purchase 50,000 -
End 20x1 41,000 9,000
End 20x2 32,000 9,000
End 20x3 23,000 9,000
End 20x4 14,000 9,000
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 Depreciation pattern
 Has to be consistent through time
 Should have a bearing on economic
reality
 Physical wear, technical or economic ageing
 Various methods:
 Straight-line method
 Diminishing balance method
 Units of production method

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 IAS 16 - Depreciation accounting
50.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

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 IAS 16 - Depreciation accounting
(cont.)
56.(a) expected usage of the asset. Usage is assessed by reference to
the asset’s 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

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 IAS 16 - Depreciation accounting
(cont.)

60. The depreciation method used shall reflect the pattern in which the
asset’s 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.

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 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 period
Source: IAS 16 - Property, Plant and Equipment

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 Straight-line depreciation

 Assumes uniform consumption pattern of

economic benefits
 The depreciation expense:

Depreciable amount = Depreciation expense

Estimated useful life

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 Diminished balance method
 Allocates a high proportion of expense to the
early years of the asset’s useful life
 Depreciation 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

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Diminishing balance depreciation rate

d= 1- n
R
A
with: d= depreciation rate
n= number of accounting periods
R= residual value
A= acquisition cost

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 Impact of depreciation method on
annual depreciation expense

Annual
depreciation
expense Diminishing
balance

Straight-line

Time
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 Impact of depreciation method on
book value of asset

Straight-line versus Diminishing balance

Original book
value

Book value

Time

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 Example diminishing value depreciation
Suppose 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.

Net book value Depreciation Net book value

start of year expense end of year
€ € €
1 1050 *45.6% = 479 (1050 – 479 =) 571
2  571 *45.6% = 260 (571 – 260 =) 311
3  311 *45.6% = 142 (311 – 142 =) 169
4  169 *45.6% =  77 (169 – 77 =)  92
5   92 *45.6% =  42 (92 – 42 =)  50

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

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 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

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 Units of production method
 Depletion method
 Fixed asset is expensed according to
physical capacity usage referents
 Estimates of resource capacity and
utilization are critical

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 Components approach
 Fixed asset components with different useful
lives or with different benefit consumption
patterns should be recognised separately
 Each component will follow proper
depreciation rules
 Subsequent expenditure to replace or renew
an asset component will be treated as the
acquisition of a new asset

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 Depreciation accounts
 Balance sheet accounts: the net value of the
asset (carrying amount or book value of the
asset) is preserved through two accounts:
 Gross (acquisition) cost
 Accumulated depreciation
 Income statement account:
 Depreciation expense of the current year
 Balances and details of these accounts are
used in supplementary disclosures in the
notes to the accounts

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 Disposal or retirement of a fixed
asset
 Derecognition of a fixed asset occurs:
 On disposal, or
 When future economic benefits are no longer expected
 Accounting effect of asset derecognition:
 Net book value of asset is eliminated in the balance sheet
 A gain or loss on disposal is recognised in the income
statement
 Gain or loss on disposal = difference between the net
disposal proceeds and the net book value of the
asset at disposal date

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Specific asset valuation problems
 Intangible fixed assets
 Research and development
 Brand names
 Patents
 Purchased goodwill
 Tangible fixed assets
 Land and buildings
 Plant and equipment
 Leased assets
 Investments
 Investments

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

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 Intangible fixed assets
 Reflect 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

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 IAS 38 - Intangibles
 An intangible is an identifiable non-
monetary asset without physical
substance
 Main characteristics:

 They meet the definition of an asset

 They lack physical substance

 They are identifiable

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 IAS 38 – Intangibles (cont.)
 Definition refers to “identifiability”
 Separability, or
 Arising from contractual or other legal rights
 Recognition criteria challenge - Degree of
uncertainty with respect to the future economic
benefits
 Magnitude and timing of future economic benefits?
 Control over economic benefits
 The useful life of an intangible asset can be
finite or indefinite

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 Research and development
 IAS 38: distinction between the research and
the development phase
 Research costs are always expensed
 Development costs may qualify for asset
recognition
 Specific recognition criteria for internally
generated intangible assets specify when
development costs should be recognised as
an asset

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 Brand names
 Expenditure on internally generated brands is
in most cases indistinguishable from the cost
of developing the business in general
 A brand name acquired from another
company will generally meet asset recognition
criteria
 Brand names can have an indefinite useful life
 If indefinite useful life, no systematic amortization
necessary

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 Patents
 Internally generated patents:
 Application of specific recognition criteria
for development costs
 Identification of the related costs can be
problematic
 Depreciation schedule can be a matter
of debate

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 Purchased goodwill
 Buying ‘customer goodwill’
 ‘Control over resources’ - issue
 Usually no legal rights to protect client
relationships
 Exchange transactions for the same or similar
customer relationships may provide evidence that
the company is able to control the expected future
benefits
 Recognition of internally generated goodwill
as an asset is prohibited by IAS 38

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 Tangible fixed assets
 IAS 16 Property, Plant and Equipment
 Acquisition 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 management
 Separate values for land and buildings
 Land usually has an indefinite useful life and is therefore
not depreciated
 In some cases acquisition cost will include capitalised
decommissioning costs
 Control over fixed assets through ownership or lease
agreement

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 Leased assets
 IAS 17 Leases
 A 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 time
 Finance lease versus operating lease
 Finance lease
 Substantially all risks and rewards of ownership of an asset
are transferred
 Lessee recognises the asset and a corresponding liability
 The asset is initially measured at fair value and subsequently
depreciated in the same way as legally owned assets
 Periodic lease payments include a principal component (to
settle the liability) and an interest expense component

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 Ownership versus lease
 Building (100,000) bought via bank loan
Assets  100,000
Liabilities 100,000
 Building leased over economic useful life
Assets  recognised at ‘fair value’ (100,000)
Liabilities  recognised at ‘fair value’ (100,000)
 Similar impact on P&L

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 Investments
 Non-current financial assets
 Investments in not-controlled companies
 Equity participations (shares)
 Long-term receivables / loans
 They should reflect a strategic (long-term)
relationship
 If no long-term relationship (only speculative
purposes) they are classified as current assets
 Specific measurement rules (see chapter 12)

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