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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

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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

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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

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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

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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

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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

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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

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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