Chapter 8
Part I: Tangible Fixed Assets
Capitalization
Concept of depreciation, Depreciation methods
Asset impairment
Depletion of natural resources
1
Fixed Assets
z
... assets used (not consumed) in operations of a
business
Œ
z
provide benefits beyond the current accounting period
Historical Cost for specific examples
Œ
Land
• historical cost includes purchase cost, legal fees, demolition
costs of old structures etc.
ΠBuildings and equipment
• historical cost includes all costs of acquisition and
preparation for use,
ΠNatural resources
• historical cost includes costs of acquiring the rights to extract
natural resources
ΠIntangible assets
• historical cost includes costs of acquiring rights or economic
benefits, such as franchises, patents, goodwill etc.
2
Fixed Asset Accounting – An Overview
Balance sheet
z
Land
z Buildings and equipment
z Natural resources
z Intangible assets (purchased)
Income statement
--depreciation
depletion
amortization /
impairment test
Depreciation: The process of allocating the cost of tangible assets to
the periods that benefit from these assets.
Depletion: The process of allocating the cost of natural resources to
the periods in which the resources are used.
Amortization: Allocation of the cost of intangible assets to the
periods that benefit from these assets. (Covered in part 2.)
3
Sidestep – Terminology
Write-downs
Depreciation/Amortization
Impairment/
One-off write-down
z
terms depreciation / amortization, the latter used in connection
with intangibles, mean systematic allocation of cost, not loss of
value
z The term impairment means loss of value
4
Capitalization: How to determine cost
z
z
IFRS 16: cost should include the purchase price and
any directly attributable costs of bringing the assets to
working condition for its intended use‘.
Example: purchase and installation of a company‘s
intranet
Œ
Œ
Œ
Œ
Œ
Œ
Œ
Catalogue list price
€ 10.000
Trade discount: 10%;
cash discount terms: 2/10, n/30
8.820
Freight cost (FOB shipping point) 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
5
Capitalization of financing cost
z
Problem
Œ
Œ
z
Possible accounting alternatives?
1.
2.
3.
z
Are costs of debt incurred to finance asset‘s construction part of
business financing as a whole? Or
are they of the same type as other indirect costs incurred to
construct the asset?
• Inconsistent accounting treatment of debt-financed and equityfinanced self-constructed assets
Do not capitalize borrowing costs.
Capitalize all cost of funds, including imputed interest.
Capitalize actual borrowing costs for „qualifying assets“ (subject
to certain conditions).
Regulation on borrowing costs:
Œ
Œ
Œ
Alternative 3 is required under US-GAAP
Alternative 1 is the ‚benchmark treatment‘ under IFRS 23 and
mandated according to German accounting principles;
alternative 2 is the ‚allowed alternative treatment‘
6
Capitalitzing interest cost
z
z
Prerequisites: expenditures have been made and
interest is being incurred
Amount to be capitalized: lower of actual interest or
avoidable interest
Œ
Avoidable interest
... the amount of interest cost that (theoretically) could have
been avoided if expenditures for the asset had not been
made („opportunity cost“ approach)
Œ Avoidable interest = (WAAE – specific borrowings) × WAIR
+ specific borrowings × SBIR
• WAAE = weighted average accumulated expenditures
• WAIR = weighted average interest rate
• SBIR = specific borrowings interest rate
7
Example
z
z
z
z
z
Coffee Queen made the following payments on the
construction of a production line in 2004:
€ 45.000 on Febr. 4th
€ 120.000 on May 1st
€ 70.000 on July 1st.
The total cost of the production line is € 275.000.
Production begins Jan. 1st, 2005.
to finance construction, a 12%, 4-year, € 100.000
note was issued on December 31, 2003.
Other outstanding debt consists of
Œ
13%, 8-year bonds with face value of € 100.000, and
Œ 10%, 10-year bonds with face value of € 150.000.
ΠInterest payments are due on December 31.
8
Determining WAAE:
Expenditures
Date
Amount
04. Feb
01. May
01. Jul
31. Dec.
45.000,00
120.000,00
70.000,00
40.000,00
× Time to going =
into operation
326
240
180
0
WAAE
40.750,00
80.000,00
35.000,00
0,00
Determining WAIR
Interest rate
13%
10%
× Amount
=
100.000,00
150.000,00
250.000,00 (a)
WAIR = (b)/(a) =
13000
15000
28000 (b)
11,20%
9
Avoidable Interest:
Specific borrowings
× SBIR
100000
12% =
WAAE - specific borrowings × WAIR
55750
11,20% =
12.000,00
6.244,00
18.244,00
Actual Interest:
Interest on specific Borrowings:
13% on
10% on
100.000,00
150.000,00
12.000,00
13.000,00
15.000,00
40.000,00
Capitalizable Interest cost (lower of (a) 18.244,00
10
Depreciation
z
z
The cost of an asset or other amount substituted for
cost in the financial statements, less its residual
value, is called depreciable amount.
Depreciation is the systematic allocation of the
depreciable amount of an asset over its useful life.
Depreciation does not refer to the physical
deterioration
or the decrease in market value of assets
Depreciation is a means of cost allocation, not
valuation.
11
The useful life of assets
z
z
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
Œ
z
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.
[IAS 16, paragraph 44)
depreciable life:
Œ
a time period, e.g. ten years, or
Πan estimate for total production or usage, e.g. 70.000 units
or 30.000 hours
z
physical deterioration and obsolescence limit useful
life
12
Depreciation is not for
z
valuation
Œ
depreciation charges reflect that assets wear out (asset
costs are charged to expense) but it does not reflect a
decline in fair market value
Πnet book value = asset cost that has not yet been allocated
as an expense
ΠImpairment is a valuation
• loss in market value
• loss in utility
• estimation and measurement problems
z
replacement
Œ
cumulative depreciation as a provision for replacement
Œ „internal financing“
ΠNote, however, that financing is a matter of cash flows not
of bookkeeping!
13
Example:
z
z
Two identical companies record identical transactions (revenues,
expenses etc.) but differ with respect to depreciation – NoDep does not
record depreciation and distributes the entire profit each year, and
WeDep does record depreciation charges and distributes the remaining
profit each year but undistributed assets are kept as current assets.
Income statement and balance sheet in year 1:
NoDep
gross profit
less expenses
net profit
WeDep
10.000
6.000
gross profit
less expenses
less depreciation
4.000 distributed
net profit
balance sheet
fixed assets
20.000
current assets
30.000
capital
profit
less distribution
50.000
10.000
6.000
2.000
2.000 distributed
balance sheet
50.000
4.000
4.000
50.000
fixed assets
less depreciation
current assets
20.000
2.000
32.000
50.000
capital
profit
less distribution
50.000
2.000
2.000
50.000
14
example adapted from Alexander/Nobes, p. 201
Assuming identical scenarios for the years ahead, company
NoDep ends up with a worthless fixed asset, while company
WeDep ends up with current assets being €20.000 higher than
for NoDep.
3.
-
Depreciation is not for tax purposes
accounting depreciation vs. tax depreciation
in most continental European countries Æ close relationship
between tax and accounting depreciation
Example: Germany
ƒ tax accounts should be based on commercial accounts (in
practice, it‘s often the other way around Æ
ƒ
i.e. tax regulations prescribe maximum depreciation rates and
companies apply them to calculate accounting depreciation
15
Accounting depreciation vs. tax depreciation
z
z
In most continental European countries: close
relationship between tax and accounting
depreciation
Example: Germany
Œ
financial accounting governs tax accounting
• matter of credibility
Πfor political reasons tax law often allows for accelerated
depreciation beyond what is adequate for the „true and fair
view“ principle of financial accounting
ΠTax law requires that accelerated depreciation is also used
in financial accounting if it is in tax accounting
Œ
tax accounting in effect governs financial accounting)
16
Typical German note to financial statements:
Plant and machinery are depreciated over a useful life of fifteen years
on a declining-balance basis; straight-line depreciation is adopted as
soon as this results in a higher charge.
Real-life example. BASF – The Chemical Company:
„Fixed assets, including long-distance natural gas pipelines,
are depreciated using the straight-line method. Movable fixed
assets put into operation before the end of 2000 are mostly
depreciated by the declining-balance method, with a change to
straight-line depreciation when this results in higher
depreciation amounts.“
Source: Annual report 2004.
17
Useful life for selected items under the
German tax regulation
z
published in so-called tax depreciation tables
Œ
subject to change
Πcompanies are allowed to choose a longer useful life for
their assets
item
useful life in years
rail vehicles
automobiles
trucks
hot-air balloon
beer tent
mobile phone
portable toilets
lathe
computer / monitor
25
6
9
5
8
5
9
16
3
¾ Federal Ministry of Finance
determines tax depreciation tables
18
in the UK, the United States, and the Netherlands:
independence of tax and financial reporting
Example: United Kingdom
Œ
accounting depreciation according to custom and prevailing
accounting standard; tax depreciation according to a
formalized scheme of capital allowances
Main capital allowances
Plant & Machinery, Patent Rights, Know-How:
writing down allowance (reducing balance)
Plant & Machinery:
First year allowance for expenditure incurred by
small sized businesses until 5.4.05
25% pa
50%
First year allowance for expendture incurred by
medium sized businesses
40%
Motor Car:
writing down allowance (reducing balance)
25% pa, max £3,000 p.a
New car registered on or after 17/04/02 emitting up
to 120g/km or electrically propelled.
100%
Enterprise Zone Buildings and Scientific
Research
100% initial allowance
Industrial and Agricultural Buildings, Hotels,
Docks, etc: writing down allowance (straight line)
4% pa
Investments in designated energy-saving plant
and machinery from 6/4/00
100%
http://www.coutts.com/marketing/corpandcap.asp
z
19
Allocation Methods
z
1.
2.
3.
4.
most common methods:
activity or usage method
straight-line method
sum-of-the-years‘-digits method
declining-balance method
Requirement: depreciation method employed must be
„systematic and rational“
z each of the four methods is „systematic“
z „rational“ depends on the context
20
1 - Activity or Usage Method
z
if assets mainly wear out through use
Œ
it is „rational“ to depreciate on the basis of usage
z
life of asset estimated in terms of output or input
z advantage: low-output (input) periods generate low
depreciation charges
estimation
e.g. based
on a
product life
cycle
Year
Units produced
Depreciation charge ( € )
1
2
3
4
5
6
7
13.000
15.000
17.000
11.000
5.000
8.000
1.000
10.400
12.000
13.600
8.800
4.000
6.400
800
70.000
€ 56.000
Depreciation charge in year 1: 10 .400 =
13 .000
⋅ 56 .000
70 .000
21
2 – Straight-Line Method
z
usability constant over time or no reasons for
another pattern
Œ
rational to spread depreciable cost uniformly over the
asset‘s life
Πfairly constant repair/maintenance cost
Year
1
2
3
4
5
6
7
Depreciation charge ( € )
10.000
10.000
10.000
10.000
10.000
10.000
10.000
Book value
€ 80.000_
70.000
60.000
50.000
40.000
30.000
20.000
10.000
€ 70.000 residual value: € 10.000
* income / average total assets
Income (after
depreciation)
5.000
5.000
5.000
5.000
5.000
5.000
5.000
Rate of
return*
6,67%
7,69%
9,09%
11,11%
14,29%
20,00%
33,33%
22
3 – Sum-of-the-Years‘-Digits Method
z
decreasing charge method
Œ
Year
1
2
3
4
5
6
7
„rational“ if asset has increasing repairs and maintenance
Depreciation base ( € )
70.000
70.000
70.000
70.000
70.000
70.000
70.000
„sum of the years“ =
Remaining
life in years
Depreciation
fraction
Depreciation
charge
7
6
5
4
3
2
1
7/28
6/28
5/28
4/28
3/28
2/28
1/28
17.500
15.000
12.500
10.000
7.500
5.000
2.500
28
28/28
€ 70.000
n ( n + 1)
2
in the example:
Book value
year-end
80.000
62.500
47.500
35.000
25.000
17.500
12.500
10.000
7 ( 7 + 1) 56
=
= 28
2
2
23
4 – Declining-Balance Method
z
(again a) declining charge method
Œ
constant percentage applied to a decreasing book value
Πno estimate of the useful life required, only a yearly
depreciation rate needed
Year
1
2
3
4
5
6
7
Depreciation base ( € )
80.000
59.440
44.164
32.813
24.380
18.114
13.459
Rate on de- Depreciation
clining balance
expense
26%
26%
26%
26%
26%
26%
26%
20.560
15.276
11.350
8.433
6.266
4.655
3.459
Balance Accumu- Book value
lated depreciation year-end
20.560
35.836
47.187
55.620
61.886
66.541
70.000
80.000
59.440
44.164
32.813
24.380
18.114
13.459
10.000
24
Determining the depreciation rate for given life
and salvage value:
SV = (1 − d ) AC
n
z
d = 1− n
SV
AC
with
ΠSV: salvage value
ΠAC: acquisition cost
Πn: useful life, and
Πd: the depreciation rate
25
Comparison of depreciation charges
z
Purchase price: € 80.000; salvage value: € 10.000;
useful life: 7 years
Depreciation charges under different methods
depreciation charge
25.000
20.000
15.000
10.000
5.000
0
1
2
3
4
5
6
7
years
straight-line
sum-of-the-years
declining balance
activity
26
Depreciation Methods Used in Practice
Units-ofproduction
5%
Other
1%
Accelerated
12%
Straight-line
82%
Source: Harrison / Horngren, p.328 – Survey of 600 companies conducted by AICPA
27
Depreciation for partial periods
z
z
z
if asset can is purchased or sold during the year:
adjust depreciation charges
two common procedures
(1) apportion depreciation charges pro rata temporis
(2) full-year or half-year depreciation charges for
assets that are on hand at year end
Example.
Œ
depreciation charges for office equipment
• purchased in February 2004
• purchase price: € 84.000
• using the straight-line method
• useful life: 7 years
• sold on 30th of April 2006
• fiscal year ends December 31.
28
Year
in service
Full-year depreciation
charge
1st full year
12.000
2004
2005
11/12
1/12
11.000
1.000
2nd full year
12.000
2005
2006
11/12
1/12
11.000
1.000
3rd full year
12.000
2006
4/12
4.000
Year
in service
Full-year depreciation
charge
Alternative 1:
Applicable
for
Applicable
for
Depreciation Depreciation
period
charge
Depreciation Depreciation
period
charge
1st full year
12.000
Alternative
2:
2004
2005
1/2
1/2
6.000
6.000
2nd full year
12.000
2005
2006
1/2
1/2
6.000
6.000
3rd full year
12.000
2006
4/12
4.000
Depreciation
2004 2005
2006
11.000
12.000
5.000
Depreciation
2004 2005
2006
6.000
12.000
10.000
29
Revisions of Depreciation Rates
z
useful life is only an estimate, subject to change
z depreciable amount can change (see next slide)
z changes are handled in current and prospective periods, no
revision of earlier periods!
z
Example : 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.
Year
Depreciation charge
1
2
3
2.000 2.000 2.000
10.000
„initial“ charges:
= 2.000
5
4
5
6
7
800
800
800
800
8
Total
800 10.000
10.000 - 6.000
revised charges:
= 800
8-3
30
Revisions of Depreciation Base
z
Postacquisition expenditures: betterments or
maintenance?
Œ
repair and maintenance cost: necessary to maintain asset
Πbetterments Рcosts incurred to improve the asset
z
What characterizes a betterment (capital
improvement, werterhöhende Großreparatur)?
Œ
Œ
Œ
Œ
Œ
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.
31
Revision of depreciation method
z
z
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%.
Year
1
2
3
4
5
6
7
8
9
10
Book Value depreciation straight line
revised
(declining balance)
depreciation depreciation
on rest
80,00
20,00
8,89
20,00
64,00
16,00
8,00
16,00
51,20
12,80
7,31
12,80
40,96
10,24
6,83
10,24
32,77
8,19
6,55
8,19
26,21
6,55
6,55
6,55
20,97
5,24
6,99
6,55
16,78
4,19
8,39
6,55
13,42
3,36
13,42
6,55
10,74
2,68
6,55
100
32
Gains and losses on sales of tangible assets
z
not every asset is held until the end of its useful life
z sales price different from current book value: gain/loss from
sales results
z 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.
Sales price
Less book value
Cost
Accumulated depreciation
Gain
1.000
Income statement presentation:
2.100
1.400
700
300
Journal entry: Cash
Accumulated depreciation
Computer equipment
Gain on sale of equipment
Æ in most cases, gains/losses
included in „other income“
1.000
1.400
2.100
300
33
Asset Impairment
z
lower-of-cost-or-market rule does not apply to plant assets
z impairment Æ carrying value higher than recoverable amount
Balance sheet value
lower of
Depreciated
cost
Calculation of a possible
impairment loss :
Recoverable
amount
impairment loss =
depreciated cost less
recoverable amount
higher of
Value in
use
Source: Alexander/Nobes, p.208
Net selling
price
34
Depletion of Natural Resources
z
z
z
applies to, for example, oil, coal, timber, ore etc.
depletion: allocation of historical cost according to
units of the resources used up
Depletion Base
Œ
acquisition cost: price paid for drilling (or timber) rights
or for an already discovered resource
Πrestoration cost: cost to relandscape property
Πdevelopment cost: (usually) only intangible development
cost
z
Problematic:
Œ
Should exploration cost be included in the depletion base ?
• usually expensed as incurred; exception: oil and gas industry
• full costing concept vs. successful efforts concept
35