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Chapter 8Part I: Tangible Fixed Assets
CapitalizationConcept of depreciation, Depreciation methods
Asset impairmentDepletion of natural resources
Fixed Assets
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... assets used (not consumed) in operations of a business
provide benefits beyond the current accounting periodHistorical 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, Natural resources • historical cost includes costs of acquiring the rights to extract
natural resourcesIntangible assets • historical cost includes costs of acquiring rights or economic
benefits, such as franchises, patents, goodwill etc.
Fixed Asset Accounting – An Overview
3
Balance sheet Income statement
Land ---Buildings and equipment depreciationNatural resources depletionIntangible assets (purchased) 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.)
Sidestep – Terminology
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Write-downs
Depreciation/Amortization Impairment/One-off write-down
terms depreciation / amortization, the latter used in connection with intangibles, mean systematic allocation of cost, not loss of valueThe term impairment means loss of value
Capitalization: How to determine cost
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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
Catalogue list price € 10.000Trade discount: 10%; cash discount terms: 2/10, n/30 8.820Freight cost (FOB shipping point) including insurance 280 Repair costs (unintentionally, a worker dropped a box) 400Wires and other fixtures 500Installation 500Initial tests; consulting fees 450
Cost to be capitalized: € 10.950
Capitalization of financing cost
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ProblemAre 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 equity-
financed self-constructed assetsPossible accounting alternatives?1. Do not capitalize borrowing costs.2. Capitalize all cost of funds, including imputed interest.3. Capitalize actual borrowing costs for „qualifying assets“ (subject
to certain conditions).Regulation on borrowing costs:
Alternative 3 is required under US-GAAPAlternative 1 is the ‚benchmark treatment‘ under IFRS 23 and mandated according to German accounting principles;alternative 2 is the ‚allowed alternative treatment‘
Capitalitzing interest cost
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Prerequisites: expenditures have been made and interest is being incurredAmount to be capitalized: lower of actual interest or avoidable interest
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)Avoidable interest = (WAAE – specific borrowings) × WAIR
+ specific borrowings × SBIR
• WAAE = weighted average accumulated expenditures• WAIR = weighted average interest rate• SBIR = specific borrowings interest rate
Example
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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
13%, 8-year bonds with face value of € 100.000, and 10%, 10-year bonds with face value of € 150.000. Interest payments are due on December 31.
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Determining WAAE:
Expenditures
Date Amount × Time to going = WAAEinto operation
04. Feb 45.000,00 326 40.750,0001. May 120.000,00 240 80.000,00
01. Jul 70.000,00 180 35.000,0031. Dec. 40.000,00 0 0,00
Determining WAIR
Interest rate × Amount =13% 100.000,00 1300010% 150.000,00 15000
250.000,00 (a) 28000 (b)WAIR = (b)/(a) = 11,20%
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Avoidable Interest:
Specific borrowings × SBIR100000 12% = 12.000,00
WAAE - specific borrowings × WAIR55750 11,20% = 6.244,00
18.244,00Actual Interest:
Interest on specific Borrowings: 12.000,0013% on 100.000,00 13.000,0010% on 150.000,00 15.000,00
40.000,00
Capitalizable Interest cost (lower of (a) 18.244,00
Depreciation
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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 deteriorationor the decrease in market value of assets
Depreciation is a means of cost allocation, notvaluation.
The useful life of assets
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determines depreciation period („depreciable life“) and depreciation chargesis 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. [IAS 16, paragraph 44)
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
Depreciation is not for
13
valuationdepreciation charges reflect that assets wear out (asset costs are charged to expense) but it does not reflect a decline in fair market valuenet book value = asset cost that has not yet been allocated as an expenseImpairment is a valuation• loss in market value• loss in utility• estimation and measurement problems
replacementcumulative depreciation as a provision for replacement„internal financing“Note, however, that financing is a matter of cash flows notof bookkeeping!
Example:
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Two identical companies record identical transactions (revenues, expenses etc.) but differ with respect to depreciation – NoDep does notrecord 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 WeDep
gross profit 10.000 gross profit 10.000less expenses 6.000 less expenses 6.000 less depreciation 2.000
net profit 4.000 distributed net profit 2.000 distributed
balance sheet balance sheet
fixed assets 20.000 capital 50.000 fixed assets 20.000 capital 50.000profit 4.000 less depreciation 2.000 profit 2.000
current assets 30.000 less distribution 4.000 current assets 32.000 less distribution 2.000
50.000 50.000 50.000 50.000
example adapted from Alexander/Nobes, p. 201
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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 close relationship
between tax and accounting depreciation
Example: Germanytax accounts should be based on commercial accounts (in practice, it‘s often the other way aroundi.e. tax regulations prescribe maximum depreciation rates and companies apply them to calculate accounting depreciation
Accounting depreciation vs. tax depreciation
16
In most continental European countries: close relationship between tax and accounting depreciationExample: Germany
financial accounting governs tax accounting • matter of credibility
for political reasons tax law often allows for accelerateddepreciation beyond what is adequate for the „true and fair view“ principle of financial accountingTax law requires that accelerated depreciation is also usedin financial accounting if it is in tax accounting
tax accounting in effect governs financial accounting)
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Typical German note to financial statements:
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.
Plant and machinery are depreciated over a useful life of fifteen yearson a declining-balance basis; straight-line depreciation is adopted as soon as this results in a higher charge.
Useful life for selected items under theGerman tax regulation
18
published in so-called tax depreciation tablessubject to changecompanies are allowed to choose a longer useful life for their assets
Federal Ministry of Financedetermines tax depreciation tables
item useful life in years
rail vehicles 25automobiles 6trucks 9hot-air balloon 5beer tent 8mobile phone 5portable toilets 9lathe 16computer / monitor 3
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in the UK, the United States, and the Netherlands: independence of tax and financial reporting
Example: United Kingdomaccounting 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)
25% pa Plant & Machinery: First year allowance for expenditure incurred by small sized businesses until 5.4.05
First year allowance for expendture incurred by medium sized businesses
50%
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%
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Allocation Methods
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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 and rational“each of the four methods is „systematic“„rational“ depends on the context
1 - Activity or Usage Method
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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 inputadvantage: 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
2 – Straight-Line Method
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usability constant over time or no reasons for another pattern
rational to spread depreciable cost uniformly over the asset‘s lifefairly 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
3 – Sum-of-the-Years‘-Digits Method
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decreasing charge method „rational“ if asset has increasing repairs and maintenance
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
2)1( +
=nn
„sum of the years“ 282
562
)17(7==
+in the example:
4 – Declining-Balance Method
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(again a) declining charge methodconstant percentage applied to a decreasing book valueno estimate of the useful life required, only a yearly depreciation rate needed
Rate on de- Depreciation Balance Accumu- Book valueYear 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
Determining the depreciation rate for given life and salvage value:
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ACdSV n)1( −= nACSVd −=1
withSV: salvage valueAC: acquisition costn: useful life, and d: the depreciation rate
Comparison of depreciation charges
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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
Depreciation Methods Used in Practice
27
Other1%
Straight-line82%
Accelerated12%
Units-of-production
5%
Source: Harrison / Horngren, p.328 – Survey of 600 companies conducted by AICPA
Depreciation for partial periods
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if asset can is purchased or sold during the year:adjust depreciation chargestwo 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 endExample.
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.
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Alternative 1:
Alternative 2:
Year Full-year depreciation Applicable Depreciation Depreciation Depreciationin service charge for period charge 2004 2005 2006
1st full year 12.000 2004 11/12 11.000 11.000 2005 1/12 1.000
2nd full year 12.000 2005 11/12 11.000 12.0002006 1/12 1.000
3rd full year 12.000 2006 4/12 4.000 5.000
Year Full-year depreciation Applicable Depreciation Depreciation Depreciationin service charge for period charge 2004 2005 2006
1st full year 12.000 2004 1/2 6.000 6.000 2005 1/2 6.000
2nd full year 12.000 2005 1/2 6.000 12.0002006 1/2 6.000
3rd full year 12.000 2006 4/12 4.000 10.000
Revisions of Depreciation Rates
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useful life is only an estimate, subject to changedepreciable amount can change (see next slide)changes are handled in current and prospective periods, no revision of earlier periods!
Example : asset with depreciation base of € 10.000 and usefullife of 5 years; in year four, useful life is reestimated to be 8 years overall.
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
2.0005
10.000= 800
3-86.000-10.000
=revised charges:„initial“ charges:
Revisions of Depreciation Base
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Postacquisition expenditures: betterments or maintenance?
repair and maintenance cost: necessary to maintain assetbetterments – costs incurred to improve the asset
What characterizes a betterment (capital improvement, werterhöhende Großreparatur)?
Increase the asset‘s useful lifeImprove the quality of the asset‘s outputIncrease the quantity of the asset‘s outputReduce the costs associated with operating the assetmaterial amount of investment relative to acquisition cost
Improvements are capitalized.
Revision of depreciation method
32
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%.
Book Value depreciation straight line revised (declining balance) depreciation depreciation
Year on rest1 80,00 20,00 8,89 20,002 64,00 16,00 8,00 16,003 51,20 12,80 7,31 12,804 40,96 10,24 6,83 10,245 32,77 8,19 6,55 8,196 26,21 6,55 6,55 6,557 20,97 5,24 6,99 6,558 16,78 4,19 8,39 6,559 13,42 3,36 13,42 6,55
10 10,74 2,68 6,55100
Gains and losses on sales of tangible assets
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not every asset is held until the end of its useful lifesales price different from current book value: gain/loss from sales resultsExample : 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 1.000Less book value Cost 2.100 Accumulated depreciation 1.400 700 Gain 300
Income statement presentation:
in most cases, gains/lossesincluded in „other income“
Journal entry: Cash 1.000Accumulated depreciation 1.400
Computer equipment 2.100Gain on sale of equipment 300
Asset Impairment
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lower-of-cost-or-market rule does not apply to plant assetsimpairment carrying value higher than recoverable amount
Balance sheet value
lower of
Depreciated Recoverablecost amount
higher of
Value in Net sellinguse price
Source: Alexander/Nobes, p.208
Calculation of a possible impairment loss :
impairment loss = depreciated cost less
recoverable amount
Depletion of Natural Resources
35
applies to, for example, oil, coal, timber, ore etc.depletion: allocation of historical cost according to units of the resources used upDepletion Base
acquisition cost: price paid for drilling (or timber) rightsor for an already discovered resource
restoration cost: cost to relandscape propertydevelopment cost: (usually) only intangible development cost
Problematic: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