Depreciation Expense
Why getting it right is so
important
(March 2013)
1
APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
Foreword
APV Valuers and Asset Management provides specialised valuation services to the public and not-for-profit
sector across the breadth of Australia. This includes valuation, asset management and asset accounting services.
Fair Value Pro is a cloud based application developed with the assistance of APV to enable entities to
undertaken their own infrastructure valuations. As a result entities now have greater flexibility and options
available to satisfy their financial reporting needs.
APV are recognised leaders in our field and we’re proud of our unblemished record. Every valuation we’ve ever
done has received unqualified audit approval – and that’s a record that won’t be broken.
Whether its land, buildings, roads, bridges, footpaths, stormwater, parks, recreational facilities, water, sewerage,
marine, airports or other types of infrastructure – APV is your one stop shop for your financial statement and
insurance valuation needs.
Over the past twenty years the Australian Accounting Standards (AASB) have undergone significant change and
in order to ensure improved transparency and accountability the valuation and depreciation requirements have
been designed with a high level of sophistication and complexity.
Unfortunately not all valuers or in-house specialists have necessarily kept up to date with the changes and as a
consequence there is a risk that some valuations and depreciation calculations may no longer comply with the
prescribed requirements.
This paper has been developed to explain the basic implications of asset revaluation in the financial statements
and to explore the impact of under/over stating depreciation expense. Anecdotally many entities report a belief
that their depreciation expense is significantly overstated. This view is supported by research undertaken by
APV over the past six years. Any comments or suggested enhancements are welcome. The booklet is also
supported by a range of material (including videos) on www.apv.net and www.fairvaluepro.com.au .
Alfio Ponticello
Managing Director
Alf@apv.net
www.apv.net
2
David Edgerton
Director
David@apv.net
www.fairvaluepro.com.au
APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
INTRODUCTION
Just as Asset Management has become more complex and sophisticated over the past twenty
years so has asset accounting. Over the past six months, as part of developing CPA Australia’s
“Guide to public sector physical asset valuation and depreciation under accrual based
accounting standards”, it has become evident that some practitioners either place limited
value on the importance of the financial statements or simply do not understand some of the
accounting concepts and requirements.
As a result some practitioners are unaware of the significant consequences of adopting
practices which ultimately result in under or over stating Depreciation Expense in the
financial statements. While such calculations may not materially impact internal decisions
they can have significant negative consequences for the council as a whole. In particular this
includes –
 Impact on Community Perception of Council Performance
 Impact on Key Performance Indicators
This paper has been developed to explain the basic processes of asset revaluation in the
financial statements and to explore the impact of under/over stating depreciation expense.
Anecdotally many entities report a view that their depreciation expense is significantly
overstated. This view is supported by research undertaken by APV over the past six years.
The cause for misstatement may be as a result of internally developed processes that use
simplistic approaches or less than adequate assumptions. Likewise it may be due to simply
relying on calculations provided by Asset Management systems without first determining
whether the calculations –



fully comply with all aspects of the standards
are based on appropriate and sound assumptions or
take an overly simplistic approach.
Irrespective of the cause, the risk associated with this issue, demonstrates the need for
entities to invest time and resources in ensuring the figures produced comply with all aspects
of the accounting standards and produce results which are materially correct.
As the financial statements and annual report are the primary accountability mechanisms for
local governments they will be assessed in the community based on the contents of these
documents and the associated KPIs derived from them. Care therefore needs to be taken to
ensure fairly present the true performance of the council.
3
APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
BACKGROUND
The calculation of depreciation expense is an essential element of financial reporting using
the accrual basis. In Australia major public sector entities that control significant assets are
required (under AASB116 Property Plant and Equipment) to value their assets at Fair Value
and to charge an annual amount for Depreciation Expense.
The estimate of this figure is extremely high and often represents between 25% and 40% of
total expenses.
Under the Australian Accounting Standards (AAS) Depreciation is defined at being –
The systematic allocation of the depreciable amount of an asset over its useful life.
To determine the amount of Depreciation Expense AASB116 requires –



4
Componentisation. Assets made up of significant parts, which in turn have different
lifecycles, must be depreciated separately.
Annual assessment for revaluation and/or depreciation changes. At the end of
each year the entity needs to assess whether the carrying amount differs significantly
from the fair value. This is done by consideration of changes in aspects such as
functionality, capacity, utilisation, obsolescence and the assessment of unit rates,
pattern of consumption of future economic benefit, residual value, useful life,
condition and as a result remaining useful life. Based on this assessment the assets
may need to be revalued and/or depreciation rates changed prospectively.
The depreciation method to – match the pattern of consumption of future economic benefit. While many
adopt methods such as straight-line as a default the standards require that the
method used matches the pattern of consumption of future economic benefit.
– be based on the appropriate factors that provide sufficient and appropriate
audit evidence to determine the level of remaining service potential and how it
is consumed
– depreciate only the depreciable amount. This requires determination of the
non-depreciable component or residual value.
– be undertaken in a systematic way over the asset’s useful life
– commence when the asset is ready for use.
APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
The process can be represented as follows –
Method of allocation of Depreciable Amount to reflect
pattern of consumption of future economic benefits
Source: IPWEA 2009 NAMS Australian Infrastructure Financial Management
Guidelines
Carrying Amount
Cost or Current Cost
Depreciable
Amount
Residual
Value
Useful Life
Legend
Increasing consumption
Constant consumption
Units (Variable) consumption
Decreasing consumption
By nature the determination of both Fair Value and Depreciation Expense is somewhat
subjective and relies upon professional judgment to determine the underlying assumptions.
When considered in light of the complex lifecycles of typical infrastructure assets (regular
renewal via cyclical maintenance) there is also a significant risk of the results being under or
over-stated. Given the high materiality of this account balance the risks associated with
material misstatement of the financial statements (and therefore audit qualification) are also
very high.
Anecdotally the calculation of depreciation expense is often miscalculated due to a
combination of –
 preference to use simplistic approaches as a quick and easy solution rather than using
methods which provide more accurate results
 preference to use easily obtainable data or generalisations/averages rather that
ensuring the data and assumptions used accurately reflect the true level of remaining
service potential and rate of consumption of the asset’s service potential
 reliance solely on algorithms embedded within Asset Management systems when such
algorithms may not reflect the prescribed requirements of the accounting standards
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APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
ISSUES
This paper focusses on impacts of reporting materially incorrect estimates of depreciation
expense. It does not focus on the calculation of depreciation expense. Extensive guidance on
the calculation of Fair Value and Depreciation Expense can be obtained from the various
technical resources provided on the APV or Fair Value Pro websites (such as the “Practical
Guide to Valuation and Depreciation”) as well as the CPA Australia’s “Guide to public sector
physical asset valuation and depreciation under accrual based accounting standards” which is
due for official release in May 2013.
Some common mistakes identified in the CPA Australia Guide in relation to Depreciation
Expense are –
 methodology does not attempt to match the pattern of consumption of future
economic benefit. Commonly entities often apply a straight-line rather than an
appropriate consumption profile.
 methodology does not take into account Residual Value. Commonly entities adopt
a zero residual value rather than taking into account the cyclical maintenance nature
of many infrastructure assets.
 methodology is based on highly subjective and unsupported assumptions.
Commonly entities adopt assumptions (such as useful life) that cannot be supported
from available evidence rather than basing the assumptions on the asset management
lifecycles and asset management plans.
 accounting data is contradicted by engineering data
 complex assets are not componentised for depreciation.
There are many risks associated with getting the depreciation figure wrong. These include –
 Impact on Community Perception of Council Performance
 Impact on Key Performance Indicators
Prior to considering these risks it is important to understand the accounting process and the
impact of changes in valuation and depreciation expense. While engineers are often involved
in the valuation and depreciation of infrastructure assets often their understanding of the
nuances of the accounting standards and associated impacts is sometimes limited.
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APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
Accounting Processes
At a basic level the financial statements contain three key statements –
 Statement of Financial Position (or Balance Sheet) which lists the value of the assets
and liabilities of the entity. The balance represents the equity or capital owned by the
community.
 Statement of Financial Performance (or Profit and Loss Account) which records the
income and expenses with the balance being a net surplus or deficit. This then flows
through to the Balance Sheet to record the net increase/decrease in community capital
over the 12 month period.
 Statement of Cashflows. This records the net cash movements during the year and is
accompanied by a disclosure note that reconciles the accrual results (Balance Sheet
and Profit and Loss Account) to the actual cashflows.
One of the common misunderstandings often described by non-accountants to APV is the
resulting impact on the financial statements as a consequence of a revaluation. The valuation
and depreciation are by nature accounting estimates and therefore from time to time will
require adjustment. These adjustments are made to reflect improved knowledge or simply
reassessments about the underlying assumptions.
The reassessment (which is required to be undertaken at the end of each year) can have a
range of consequences –
 The entire class of assets is revalued (upwards or downwards)
 Individual assets are revalued downwards (impairment)
 Providing the impact is not overly material – some individual assets may be revalued
upwardly
 Assets are not revalued but depreciation expense is adjusted prospectively
 No changes to either valuation or depreciation
If the assets are revalued the resulting adjustment may pass through either the Balance Sheet
or the Profit and Loss Account. Usually the value increases and a journal processed to
increase the value of the asset which in turn increases the value of the community equity. As a
result the adjustment is only to the assets and equity and therefore there is no impact on the
Profit and Loss Account.
The only time the Profit and Loss Account is impacted is the rare circumstances when the
valuation decreases and the impact is greater than the accumulation of all previous increases
in the value of all assets within the same asset class. In this rare scenario an expense is
recorded in the Profit and Loss Account.
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APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
As the revaluation process adjusts for these changes some practitioners are of the mistaken
belief that getting these figures wrong is not that big an issue. They argue that the figures are
simply non-cash accounting estimates, they are constantly changing and simply get revised
every couple of years. Therefore any error or reassessment is later corrected via the
revaluation process.
However this view is focused purely on the impact on the Balance Sheet and does not take
into account the impact on the Profit and Loss Account. While the Balance Sheet figures are
adjusted at every revaluation the figures in the Profit and Loss Account are not automatically
adjusted to reflect the changing assessment of the underlying assumptions and depreciation
expense.
Depreciation Expense is based on the value of the asset and the underlying depreciation
assumptions. If as a consequence of these assumptions too much depreciation expense is
charged once it is charged to the Profit and Loss Account, it cannot be retrospectively
adjusted in future years. If too much depreciation is expensed the value of the asset is later
revalued upwards and the restated depreciation expenses is expensed for a second time
through the Profit and Loss again.
The following diagram demonstrates that if depreciation expense is regularly over-stated
(even though the value is corrected via revaluation) the amount of depreciation expensed
over the useful life of the asset will be much more than that required to be depreciated. The
net impact is that the financial results of the entity will continually present a level of
performance much worse than the reality.
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APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
To help explore the risk associated with the calculation of depreciation expense the following
example is provided. It includes a typical council result (Base Figures) and the comparison if
Depreciation Expense had not been over-stated by 15%. It should be noted that after
revaluation using more sophisticated methodologies councils often experience a reduction in
depreciation expense of 40% - 60%.
The base figures report a net deficit of $500,000 whereas, if depreciation expense had been
more correctly reported at 15% lower, the council would have reported a net surplus of
$475,000. This represents a net turn-around of almost $1 million.
Base Figures
Income
Rates
Grants
Other Income
Expenses
Depreciation Expense
Other Expenses
Prop %
If depreciation
had not been
over-stated by
15% Prop %
10,000,000
5,000,000
3,000,000
18,000,000
10,000,000
5,000,000
3,000,000
18,000,000
6,500,000 35.1%
12,000,000 64.9%
18,500,000 100.0%
5,525,000 31.5%
12,000,000 68.5%
17,525,000 100.0%
Net Surplus (Deficit)
(500,000)
Net Change
Depreciation Expense
Total Expense
Net Surplus (Deficit)
$
%
(975,000) -15.0%
(975,000)
-5.3%
975,000 -195.0%
475,000
Impact on Community Perception of Council Performance
As not-for-profit entities local governments are expected to provide the community with a
range of services but with an over-riding expectation that the services will be delivered
efficiently and cost-effectively. As a result there is a community expectation that the local
government will recover costs, be financially diligent, ensure intergenerational equity and be
sustainable. In practice, for many in the community, this translates into the financial results
reporting a small surplus.
9
APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
If a council continues to record deficits many become concerned with the long term financial
viability and sustainability of the council. Some also become concerned about the level of
service they are receiving and opens the council up for criticism of poor management.
Using the above example:
A reduction in depreciation expense of 15% would have resulted in a significant
change in the Net Surplus (Deficit).
It should be remembered that for many ratepayers the only information they may
have on the financials is that reported in the local media. In this case the council will
either be reported as producing a significant deficit ($500,000) or a surplus $475,000.
In reality the actual cost to provide the services to the community is the same under
both scenarios. The only difference is the calculation of depreciation expense. The
difference in community expectation of performance and capability is significantly
different purely because of the results reported in the financial statements.
Using the base data the results raise concerns with sustainability and the ability to
deliver a high level of financial performance. Whereas if depreciation expense was
reduced by 15%: the results would project a vastly different view: strong financial
management and sustainability.
Given the significance of depreciation expense on total expenses it is critical that the annual
estimate of depreciation expense is not materially misstated. Anecdotally many councils
indicate their belief that their depreciation expense is significantly overstated.
It should also be noted that even if the depreciation assumptions were amended in the
following year the results of the previous financial year would not be adjusted. The net deficit
($500,000) would still be carried forward as an accumulated loss into the current financial
year.
Impact on Key Performance Indicators
Increasingly local governments are being compared to others using a range of Key
Performance Indicators based on the results reported in their financial statements. These
indicators are used by a range of entities to assess the performance of local governments,
determine the allocation of grant funding and in some jurisdictions form the basis of a report
to parliament. Clearly getting these figures correct has many implications well beyond how
they may be used internally.
10 APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
Some of these indicators require the amount of depreciation expense as a direct input while
others use the total expenses or other figures (such as net surplus/deficit) which are directly
impacted from the calculation of depreciation expense.
For example each year the Victorian Auditor General’s Office (VAGO) provides a summary of
the performance of local governments. In relation to sustainability the VAGO report provides
an analysis using a range of KPIs to measure the short and long term sustainability. Those
directly impacted by the level of depreciation expense include Indicator
Formula
Description
Underlying
result
(per cent)
Capital
replacement
Indicator Formula
Description
Indicator Formula Description
Adjusted net
surplus/
total underlying
revenue
A positive result indicates a surplus. The larger the
percentage, the stronger the result. A negative result
indicates a deficit. Operating deficits cannot be
sustained in the long term.
Capital expenditure/
depreciation
Underlying revenue does not take into account noncash developer contributions and other one-off (nonrecurring) adjustments.
Comparison of the rate of spending on infrastructure
with its depreciation.
Ratios higher than 1:1 indicate that spending is faster
than the depreciation rate.
Renewal gap
Renewal and
upgrade
expenditure/depreci
ation
This is a long-term indicator, as capital expenditure
can be deferred in the short-term if there are
insufficient funds available from operations, and
borrowing is not an option.
Comparison of the rate of spending on existing assets
through renewing, restoring, and replacing existing
assets with depreciation. Ratios higher than 1:1
indicate that spending on existing assets is greater
than the depreciation rate.
Similar to the investment gap, this is a long-term
indicator, as capital expenditure can be deferred in
the short term if there are insufficient funds available
from operations, and borrowing is not an option.
The results are presented in a number of ways. This includes high level analysis at a sector
level as well as for individual councils. Some examples from the VAGO report are shown
below.
11 APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
Some commonly used indicators in other jurisdictions which are impacted by the amount of
depreciation expense include –
Operating surplus
The operating surplus (or deficit) before amounts received specifically for new or
upgraded assets and physical resources received free of charge.
Operating surplus ratio
1. The percentage by which the operating surplus or deficit as defined above varies
from the major controllable income source (for example, rate income).
2. The percentage by which the operating surplus or deficit as defined above varies
from the major controllable income source plus predictable operating grants.
Asset sustainability ratio
The ratio of asset replacement expenditure relative to depreciation for a period. It
measures whether assets are being replaced at the rate they are wearing out.
12 APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
Average Rate of Depreciation.
This ratio simply compares the total amount of depreciation for each asset class as a
percentage of the total value of the asset class. If this rate increases over time it may
indicate underlying issues with the effectiveness of the asset management framework.
It may also be useful for benchmarking against similar entities.
The example provided earlier demonstrates that a 15% change in the amount of depreciation
expense resulted in a 195% change in the amount of net surplus/deficit. Such major changes
in turn will have significant impacts of the various Key Performance Indicators identified
above. Such changes may be the difference between being assessed as “good” verses “of
concern”.
As noted previously, any reassessment of the depreciation assumptions in future years will
not change the KPIs reported in previous or the current year. For this reason it is critical that
care is taken with the depreciation expense methodology and assumptions to ensure the
amount of depreciation expense is not over-stated.
Even if a revaluation is undertaken, the impact of changes to depreciation expense that was
recorded in prior years cannot be reversed. If depreciation is overstated every year (as
commonly reported) the KPIs will continue to report the financial performance of the entity
as being worse than the reality.
13 APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)
CONCLUSIONS
The calculation of depreciation expense is an essential element of financial reporting for most
public sector entities. The estimate of this figure is extremely high and often represents
between 25% and 40% of total expenses.
Anecdotally many entities report a belief that their Depreciation Expense is significantly
overstated. Research undertaken by APV over the past six years would support this view. It is
not uncommon for depreciation expense to reduce by 40% - 60% when entities adopt more
sophisticated approaches (such as those used by APV) that better reflect the asset
management reality. Often the reason for over-stated depreciation is due to –
 preference to use simplistic approaches as a quick and easy solution rather than using
methods which provide more accurate results
 preference to use easily obtainable data or generalisations/averages rather than
ensuring the data and assumptions used accurately reflect the true level of remaining
service potential and rate of consumption of the asset’s service potential
 reliance solely on algorithms embedded within Asset Management systems when such
algorithms may not reflect the prescribed requirements of the accounting standards
The implications of overstating depreciation expense are significant. While it may not
necessarily impact internal asset management decisions, because the role financial
statements play in the accountability framework and due to the materiality of depreciation
expense and its influence on the overall financial result, it can significant detrimental
implications in relation to –
 Impact on Community Perception of Council Performance
 Impact on Key Performance Indicators
It should also be noted that even though revaluations adjust the values reported in the
Balance Sheet the impact of under or over depreciation is not retrospectively adjusted in the
Profit and Loss Account. As a consequence a fundamental flaw or embedded issue with the
depreciation methodology will continually impact the entity through continued production of
misstated results and KPIs.
APV is proud of its unblemished audit record and through the use of its asset management
based methodologies is able to provide confidence that the level of depreciation expense will
better match the actual rate of consumption. Typically this results in a reduction of 40% 60% in total depreciation expense.
14 APV Valuers and Asset Management
Depreciation Expense: Why getting it right is so important
(March 2013)