Depreciation of Property, Plant and Equipment

Chapter 5
Depreciation of property,
plant and equipment
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e
5-1
Objectives of the lecture

Understand the role of accounting in allocating
the depreciable amount of a non-current asset
over the assets expected useful life
Be aware of factors that must be considered in
determining the useful life of a depreciable asset
Understand the various approaches (straight
line, sum-of-digits, declining balance, production
basis) for allocating the depreciable amount of a
non-current asset to particular financial periods

5-2
Objectives (cont.)
Understand when to start depreciating a
depreciable asset
Know the disclosure requirements of
AASB 116 Property, Plant and Equipment as
they pertain to depreciation

5-3
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

5-4
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 assets carrying amount
should not be confused with the decline in market
value of an asset over time

5-5
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, so the selection of depreciation method can
have significant implications for profits

5-6
Introduction (cont.)
In determining how to allocate the cost of an

asset three issues must be addressed
1. Which depreciable base should be used for the
asset?
2. What is the assets useful life?
3. Which method of cost apportionment is most
appropriate for the asset?

5-7
Depreciable amount (base) for assets

Depreciable amount (also referred to as depreciable
base)
Historical cost of a depreciable asset (or revalued amount)
less its residual value
Residual value
The estimated amount expected to be obtained from
disposal of the asset at the end of its useful life less the
estimated costs of disposal (AASB 116)
Usually based on professional judgment
Choice of residual value impacts on future profits and
recorded assets
If the residual value is equal to or greater than the assets
carrying amount, no depreciation is recognised (AASB 116,
par. 54)

5-8
Determination of useful life

Useful life (AASB 116)
An assets useful life:
- is the period over which an asset is expected to be
available for use; or
- the number of production or similar units expected to be
obtained from an asset
Useful life is based on professional judgment

5-9
Determination of useful life (cont.)

Factors to consider (AASB 116)
Wear and tear through physical use
Technical obsolescence (out of date as a result of
technological advances)
Commercial obsolescence (fall in market demand for
goods and services produced by the asset)
Legal life, e.g. patents, licences, franchises and
copyrights
Refer to Worked Example 5.2 (p. 178)

Determination of useful life

5-10
Method of cost apportionment

Should best reflect the economic reality of the
assets use
Must consider underlying physical, technical,
commercial and/or legal facts (AASB 116)
Available methods
straight-line method
sum-of-digits method
declining-balance method
units-of-production basis
Refer to Worked Example 5.3 (p. 179)A review

of alternative depreciation methods
.

5-11
Straight-line method
Depreciation expense is calculated as:
Cost Residual (salvage) value
Useful life
This method is appropriate when benefits to be
derived from the asset are expected to be
uniform throughout the assets useful life

5-12
Sum-of-digits method
(Cost less residual value) is multiplied by successively
smaller fractions to calculate depreciation expense
Numerator in fraction
Changes each year, and is the years remaining of the
assets useful life at the beginning of the period
Denominator in fraction
Calculated by adding the years in the assets useful life; or
n(n +1)/2 where n is the useful life
This method is appropriate when economic benefits

expected to be derived are greater in the early years than
later years

5-13
Declining-balance method
Depreciation expense is calculated on the
assets opening written-down value
Written-down value
Cost (or revalued amount) less accumulated
depreciation
Percentage used for depreciation expense is

calculated as 1 nth root of (residual value cost)
This method is appropriate when economic
benefits expected to be derived are greater in
the early years than in later years

5-14
Production basis
Depreciation expense is calculated as:
Units produced in current period x (cost residual value)
Total expected production
This method is appropriate where useful life might be

related more to production output than time

5-15
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
Accounts for obsolescence rather than wear and tear

5-16
Revision of depreciation rate and method

Residual value and useful life must be reviewed
at least annually (AASB 116)
If expected useful life or residual value are
different from that previously expected:
entity must revise depreciation rate
Depreciation method must also be reviewed

annually (AASB 116):
method to be changed where there is a significant
change in pattern of benefits

5-17
Revision of depreciation rate and method

(cont.)
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

5-18
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

5-19
Modifying existing non-current assets

When modifications or improvements are made to existing noncurrent assets and the expenditure is material and considered
to enhance the service potential of the asset, such expenditure
should be capitalised to the extent that particular accounting
standards do not preclude such capitalisation (e.g. AASB 138
prohibits the capitalisation of expenditures on certain types of
intangible assets)
Where expenditure is capitalised, the expenditure would
subsequently be depreciated to the entitys statement of
comprehensive income
The depreciable amount of any addition or extension to an
existing depreciable asset that becomes an integral part of that
asset must be allocated over the remaining useful life of that
asset
The depreciable amount of any 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
must be allocated independently of the existing asset, and on
the basis of its own useful life

5-20
Derecognition of assets
Gain or loss from derecognition of asset
Difference between net disposal proceeds (measured
at fair value) and assets carrying amount (AASB 116)
Derecognition means (AASB 116):

disposal of an asset (perhaps through a sale); or
when no future economic benefits are expected in
respect of an asset

5-21
Sale of a depreciable asset

The profit or loss on sale is generally referred to as a gain
or loss on sale (or de-recognition)
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
Dr
Cr
Cr
Cash at bank
Accumulated depreciationMachinery
Gain on sale of machinery
Machinery

5-22
IllustrationWorked Example 5.5

Sandon Point acquired an item of machinery on 1
July 2008 for a cost of $100 000
When the asset was acquired it was considered that
the asset would have a useful life to the entity of five
years, after which time it would have no residual
value
It was considered that the pattern of economic
benefits would best be reflected by applying the sum
of digits method
Contrary to expectations, on 1 July 2010 the asset
was sold for $70 000
What was the profit on disposal and what are the
journal entries to record the disposal?

5-23
IllustrationSolution
For an asset with a useful life of five years the sum-of-digits
depreciation is: n(n + 1) 2 = 5 6 2 = 15
First year depreciation = 5 15 $100 000 = $33 333
Second year depreciation = 4 15 $100 000 = $26 667
Total accumulated depreciation at 1 July 2010 = $60 000

Therefore the carrying amount of the asset is $40 000, made
up of the historical cost of $100 000 less the accumulated
depreciation of $60 000
The accounting entry would be:
Dr Cash at bank
Dr Accumulated depreciationmachinery
Cr Gain on sale of machinery
Cr Machinery

70 000
60 000
30 000
100 000
5-24
What if the sale proceeds are deferred?

When the receipt of the sale proceeds on the disposal of an
item of property, plant and equipment is deferred for a period of
time, AASB 116, paragraph 72, requires the fair value of the
consideration to be recognised initially at its cash price
equivalent. Specifically, paragraph 72 states:
The consideration receivable on disposal of an item of
property, plant and equipment is recognised initially at its
fair value. If payment for the item is deferred, the
consideration received is recognised initially at the cash
price equivalent. The difference between the nominal
amount of the consideration and the cash price equivalent is
recognised as interest revenue in accordance with AASB
118 reflecting the effective yield on the receivable
The discount rate to be used is the rate at which the vendor
could invest the amount under similar terms and conditions

5-25
Contractual implications of building

depreciation
Recognition of building depreciation will increase
expenses and decrease profits
Likely to lead to unfavourable movements in
accounting-based ratios
Managers facing possible debt-covenant violations
would be less inclined to want to comply with AASB
116

5-26
Contractual implications of building

depreciation (cont.)
Clinch (1983) found the following cash-flow
effects associated with the decision to
comply/not comply with the requirement to
depreciate buildings:
non-compliance with depreciation requirement led to
greater auditing costs
benefits included cost savings associated with
avoiding violation of debt contracts

5-27
Is allocating historical cost of an asset over

its useful life really that appropriate?
As we will learn in subsequent weeks, non-current
assets such as plant and equipment, land, and
buildings can be carried at cost, or can be revalued
to fair value
If an asset is carried at cost, and that amount is
depreciated over the expected useful life, while at
the same time the organisation is paying out all
profits in the form of dividends, what happens if the
cost to replace the asset has quadrupled across the
life of the asset?
Have profits tended to be overstated in real terms?
Have dividend payments tended to be excessive?
.

5-28
Disclosure requirements
For each class of property, plant and equipment
the following must be disclosed (AASB 116):
Measurement basis used for gross carrying amount

Depreciation methods used
Useful lives or depreciation rates used
Gross carrying amount and accumulated depreciation
at beginning and end of period
Reconciliation of carrying amount at beginning and
end of period

5-29
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
Determination of useful life depends on
judgments
Depreciation method used should reflect pattern
of benefits being derived from assets use

5-30
Summary (cont.)
Available methods include: straight line, sum-of
digits, declining 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

5-31

Depreciation of Property, Plant and Equipment

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Chapter 5

Copyright 2010 McGraw-Hill Australia Pty Ltd

Objectives of the lecture

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Relevant accounting standards

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

In determining how to allocate the cost of an

Copyright 2010 McGraw-Hill Australia Pty Ltd

Depreciable amount (base) for assets

Copyright 2010 McGraw-Hill Australia Pty Ltd

Determination of useful life

Useful life is based on professional judgment

Copyright 2010 McGraw-Hill Australia Pty Ltd

Determination of useful life (cont.)

Refer to Worked Example 5.2 (p. 178)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Method of cost apportionment

Refer to Worked Example 5.3 (p. 179)A review

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

This method is appropriate when economic benefits

Copyright 2010 McGraw-Hill Australia Pty Ltd

Percentage used for depreciation expense is

Copyright 2010 McGraw-Hill Australia Pty Ltd

Total expected production

This method is appropriate where useful life might be

Copyright 2010 McGraw-Hill Australia Pty Ltd

When to start depreciating an asset

Copyright 2010 McGraw-Hill Australia Pty Ltd

Revision of depreciation rate and method

Depreciation method must also be reviewed

Copyright 2010 McGraw-Hill Australia Pty Ltd

Revision of depreciation rate and method

Copyright 2010 McGraw-Hill Australia Pty Ltd

Land and buildings

Copyright 2010 McGraw-Hill Australia Pty Ltd

Modifying existing non-current assets

Copyright 2010 McGraw-Hill Australia Pty Ltd

Derecognition means (AASB 116):

Copyright 2010 McGraw-Hill Australia Pty Ltd

Sale of a depreciable asset

Copyright 2010 McGraw-Hill Australia Pty Ltd

IllustrationWorked Example 5.5

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Total accumulated depreciation at 1 July 2010 = $60 000

Copyright 2010 McGraw-Hill Australia Pty Ltd

What if the sale proceeds are deferred?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Contractual implications of building

Copyright 2010 McGraw-Hill Australia Pty Ltd

Contractual implications of building

Copyright 2010 McGraw-Hill Australia Pty Ltd

Is allocating historical cost of an asset over

Copyright 2010 McGraw-Hill Australia Pty Ltd

Measurement basis used for gross carrying amount

Copyright 2010 McGraw-Hill Australia Pty Ltd