Depreciation and Depletion

Transcription

1 Principles Depreciation and Depletion Prof.Sherif Sabry Spring Depreciation and Depletion Lecture outline Concept of depreciation What depreciation is not for Depreciation methods Asset impairment Depletion of natural resources Prof.Sherif Sabry Spring

2 Depreciation and Depletion What do we mean by depreciation? Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount is the cost of an asset or other amount substituted for cost in the financial statements, less its residual value. Depreciation is a mean of cost allocation, not valuation. Depreciation does not refer to the physical deterioration or the decrease in market value of assets! Prof.Sherif Sabry Spring Depreciation and Depletion The useful life of assets determines depreciation period ( depreciable life ) and depreciation charges The useful life of an asset is defined in terms of the asset s expected utility to the enterprise. The asset management policy of an enterprise may involve 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 units or hours physical deterioration and obsolescence as limiting factors Prof.Sherif Sabry Spring

3 Depreciation and Depletion What depreciation is not for 1. Depreciation is not for valuation - depreciation charges reflect that assets wear out (asset costs are charged to expense) but it does not reflect a decline in fair market value - net book value asset cost that has not been allocated as an expense - depreciation as a valuation device estimation and measurement problems loss in market value loss in utility 2. Depreciation is not for replacement - potential misconception: depreciation provides funds for replacement of assets - depreciation may aid replacement of assets Prof.Sherif Sabry Spring Depreciation and Depletion Example 1: Funds provided by a loan are used to purchase an asset. Assuming that it is the only asset used to generate revenues, cash saved through depreciation is used to pay the principal of the loan. Example 2: An asset purchased with funds provided by owner s investment is used but no revenues are generated over the asset s useful life. At the end, both the book value of the asset and owner s equity are zero, and no funds are available to replace the asset. Example 3: 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. Prof.Sherif Sabry Spring

4 Depreciation and Depletion The income statements and balance sheets for the first year: NoDep WeDep gross profit gross profit less expenses less expenses less depreciation net profit distributed net profit distributed balance sheet balance sheet fixed assets capital fixed assets capital profit less depreciation profit current assets less distribution current assets less distribution example adapted from Alexander/Nobes, p.199 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 higher than for NoDep. Prof.Sherif Sabry Spring Depreciation and Depletion 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: Germany - tax accounts (Steuerbilanz ) should be based on commercial accounts (Handelsbilanz ) principle of congruence (Maßgeblichkeitsprinzip ) - in practice, it s often the other way around tax regulations prescribe maximum depreciation rates and companies apply them to calculate accounting depreciation 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. Prof.Sherif Sabry Spring

5 Depreciation and Depletion Useful life for selected items under the German tax regulation: published in so-called AfA-Tabellen (tax depreciation tables) subject to change companies are allowed to choose a longer useful life for their assets item useful life in years rail vehicles 25 automobiles 6 trucks 9 hot-air balloon 5 beer tent 8 mobile phone 5 portable toilets 9 lathe 16 computer / monitor 3 Federal Ministry of Finance determines tax depreciation tables for a complete list: Prof.Sherif Sabry Spring Depreciation and Depletion in the UK, the United States, and the Netherlands difference between tax and financial reporting numbers Example: United Kingdom - accounting depreciation according to custom and prevailing accounting standard - tax depreciation according to a formalized scheme of capital allowances Main Capital Allowances, 2000/1 Plant & Machinery, Patent Rights,Know-How: writing down allowance (reducing balance) 25% p.a. Plant & Machinery: expenditure incurred by small and medium sized businesses 40% Motor Car: writing down allowance (reducing balance) 25% p.a., max 3,000 p.a Enterprise Zone Buildings and Scientific Research 100% initial allowance Industrial and Agricultural Buildings, Hotels, Docks, etc: writing down allowance (straight line) 4% p.a. Information and Communication Technology Equipment (Small businesses from 1/4/00 for 3 years) 100% Investments in designated energy-saving plant and machinery from 6/4/00 100% Commercial Buildings 0% $4: : ,7 0989, 709: ,85 Prof.Sherif Sabry Spring

6 Depreciation and Depletion Prof.Sherif Sabry Spring Depreciation and Depletion 2 Straight-Line Method asset subject to creeping obsolescence rational to spread depreciable cost uniformly over the asset s life underlying conceptual assumptions fairly constant usefulness over time fairly constant repair/maintenance cost Income (after Rate of Year Depreciation charge ( ) Book value depreciation) return* _ ,67% ,69% ,09% ,11% ,29% ,00% ,33% residual value: * income / average total assets Prof.Sherif Sabry Spring

7 Depreciation and Depletion 3 Sum-of-the-Years -Digits Method decreasing charge method rational if assets have increasing repairs and maintenance Remaining Depreciation Depreciation Book value Year Depreciation base ( ) life in years fraction charge year-end / / / / / / / n( n + 1) = / (7 + 1) 2 56 = 2 sum of the years in our example: 28 Prof.Sherif Sabry Spring 2009 C. Lukas / Accounting Principles / Topic 15 7 # 15 = 6

8 Depreciation and Depletion Practical Difficulties Depreciation for partial periods assets can be purchased and sold at any date during the year adjust depreciation charges two ways of handling the problem (1) apportion depreciation charges (2) full-year depreciation charges for assets that are on hand at year end Example : Let s determine depreciation charges for office equipment that was purchased in February 2000, purchase price of and is sold on May 1, A useful life of 7 years is assumed. Furthermore, let s assume that the fiscal year ends December 31. a) straight-line method b) sum-of-the-years -digits c) double-declining-balance Prof.Sherif Sabry Spring Depreciation and Depletion a) it s a simple task for the straight-line method, Straight-line method Year Full-year depreciation Applicable Depreciation Depreciation Depreciation charge for period charge st full year / / nd full year / / rd full year / b) and it s also simple for the sum-of-the-years -digits method Sum-of-the-years'-digits Year Full-year depreciation Applicable Depreciation Depreciation Depreciation charge for period charge st full year / / nd full year / / rd full year / Prof.Sherif Sabry Spring

9 Depreciation and Depletion and it doesn t become difficult if we apply the double-declining-balance method: Double-declining balance method (28,5%) Year Full-year depreciation Applicable Depreciation Depreciation Depreciation charge for period charge st full year / / nd full year / / rd full year / Prof.Sherif Sabry Spring Depreciation and Depletion Revisions of Depreciation Rates useful life only an estimate, subject to change changes are handled in current and prospective periods no revision of earlier periods! Example : asset with depreciation base of and useful life of 5 years; in year four, useful life is estimated to be 8 years overall. Year Total Depreciation charge initial charges: = revised charges: = Prof.Sherif Sabry Spring

10 Depreciation and Depletion Asset Impairment lower-of-cost-or-market rule not applicable for plant assets impairment carrying value lower than recoverable amount Balance sheet value Depreciated cost lower of Recoverable amount higher of Calculation of a possible impairment loss : impairment loss = depreciated cost less recoverable amount Value in use Source: Alexander/Nobes, p.208 Net selling price Prof.Sherif Sabry Spring Depreciation and Depletion Depletion of Natural Resources applies to, for example, oil, coal, timber, ore etc. depletion allocation of cost according to units of the resources used up Depletion Base acquisition cost price paid for drilling (or timber) rights or for an already discovered resource restoration cost cost to relandscape property development cost only intangible development cost 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 Prof.Sherif Sabry Spring

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