Non-current assets: Property, plant and equipment, and intangibles ‘SMART TOUCH LEARNING Balance sheet ‘as at 30 June 2014 How do we determine what value to report for our assets? Assets Liabilities Current assets: Current liabilities ash 5 4800 ‘Accounts payable ‘Accounts receivable 2600 Salary payable Inventory 30500 Interest payable Supplies 600 Unearned service revenue Prepaid rent 2.000 Total current liabilities ~ $0100 ‘Total current assets $ 40500 Non-current liabilities: Non-current assets: Loans payable 20000 Furniture 318000 Total liabilities “70100 Less: Accumulated depreciation—furniture 300.17 700 Building "48.000 Less: Accumulated depreciation—building 200 ‘Owners’ equity Total non-current assets Sheena Bright, capital __ 35900 Total assets Total abilities and owners’ equity $106 000 LO1 Measure the cost ofa non- ‘u've been working at your business now for a few months. Nee Things are going great—sales are increasing every month. Until BE cares nom yuve been handing the paper any Bu yu peace tea Reed beter wa) eep up i a Yous conscetg eae buying several laptop computes evan computer saat The 1a SH pereauatonota [fol cos afte sytem nung tlt, wl be 2000 Ths wil Neb ponerse you epee the business more ect, Bt what about the cos ofthe LOS Account for natural resources: system? Do you expense it all or set up asset accounts for each of the assets? ibe recurterimangieasats Wow long da you tink esc corponent will fore you ned toupee you computes? How do you recoveaeh the com of he Stem he The computer stem you plan by fy busines one pe of en caren ir Other pes nce bugs eaipmert an ite fojreegry of non caren ott etre 8 propery, lar and(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES ‘equipment. Non-current assets have some special characteristics. For example, you hold them for use in the business—not to sel as inventory. Also, + Non-current assets are relatively expensive. +The full costinvested in non-current assets can be a challenge to determine because of the difficulty of tracking installation, shipping and other costs related to the asset. + Non-current assets usually ast several years and, as a result, their cost should be allocated over the years they are expected to be used. + Non-current assets may be sold or traded in. Accounting for the disposal of a non-current asset is important because the disposal may create @ gain or loss that must be reported on the income statement. [As you can see, non-current assets pose some accounting challenges. Generally, non-current assets ‘ean be classified into three main categories: 1 Property, plant and equipment (tangible assets). This includes assets whose physical character- isties define their utility or usefulness, such as buildings, desks and equipment. 2. Natural resources. This includes assets that come from the ground and can ultimately be used up, For example, cil, diamonds and coal are all natural resource assets. 3 Intangible assets. This includes assets whose value is not derived from their physicality. For example, software programs on a CD are intangible assets. The ‘physical CD is not the value—the knowledge/ programs on the CD really represent the asset. Non-current assets have their own terminology. Exhibit 10-1 shows which expense account applies to each category of asset, ‘You probably own a car—perhaps a Holden or a ‘Toyota. Your car is a non-current asset if you use it for day-to-day operations. But if you bought the car to resell it, then it wouldn't be a non current asset; it would be part of your inventory. As your car wears out, it depreciates in usefulness. You should record depreciation on all the non-current assets used in a business, except for land. Assets that deteriorate in their usefulness are also called depreciable assets. Tn this chapter, we will conclude our coverage of assets, except for investments. After completing this chapter, you should understand the various non-current assets ofa business and how to account for ther. Along the way, well look at how both Smart Touch Learning and Greg’s Tunes account for their non-current assets. 457 EXHIBIT 10-1 Non-current assets and their related expenses Non-current asset releted expense RDO)458 Measure the cost of ‘anon-current asset EXHIBIT 10-2 Measuring the cost of and (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES BOM ren Reed Use UU Cr yur “The cost principle says to carry a non-current asset at its cost—the amount paid for the asset. The general rule for measuring cost is: ‘Sum of al the costs incurred to bring the asset ae toits intended purpose, net of all discounts “The relevant standard on accounting for these assets is AASB 116, Property, Plant and Equipment. “The cost of an item of property, plant or equipment is its purchase price plus charges such as customs duty, purchase commissions and all other amounts paid to ready the asset for its intended use. In Chapter 6, we applied this principle to inventory. These costs vary, so we discuss each asset individually Land and land improvements “The cost of land is not depreciated. It includes the following costs paid by the purchaser: + purchase price + agent's commission + government stamp duty and other charges + survey and legal fees «+ cost of clearing the land and removing any unwanted buildings. ‘The cost of land does not include the following costs: + fencing + paving + sprinkler systems + lighting, + signs. “These separate assets—called land improvements—are subject to depreciation. Suppose Smart Touch needs property and purchases land for $5000, Smart Touch also pays: cash as follows: $4.000 in agent's commission, $2000 in legal fees and stamp duty, $5000 to remove an old building and a $1 000 survey fee. What is the business’ cost of this land? Exhibit 10-2 shows all the costs incurred to bring the land to its intended use. Suppose you borrow $50000 to buy the land and pay cash for the related costs. Your entry to record purchase of the land is 2015 Aug! Land (a+) 62000 Loan payable (L+) 50.000 Cash_(A-) 12000 Purchase price of land $50 000 | Add related costs | Agent’s commission $4000 | Legal fees and stamp duty 2000 Removal of building 5.000 Survey fee 11000 12.000 Total cost of land 362000(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES We would say that Smart Touch capitalised the cost of the land at $62000. This means that an asset account was debited (increased) because the business acquired an asset. So, for our land example, Smart Touch debited the Land account for $62,000, the capitalised cost ofthe asset. ‘Suppose Smart Touch then pays $20 000 for fences, paving, lighting, landscaping and signs on 15 August 2015. The following entry records the cost of these land improvements: 2015 ‘Aug 15 Landimprovements (A+) 20000 Cash_(A-) 20000 Land and Land improvements are two entirely separate assets, Recall that land is not depreciated. However, the cost of land improvements is depreciated over that asset's useful life. Buildings “The cost of a building depends on whether the company is constructing the building itself or is buying an existing one. These costs include the following: Constructing a building Purchasing an existing building + architectural fees + purchase price + building permits, + costs to renovate the building to ready the + contractor charges building for use, which may include any + payments for material labour and overhead —_of the charges listed under ‘Constructing @ + capitalised interest cost, if self-constructed building’ Machinery and equipment ‘The cost of machinery and equipment includes its: + purchase price (less any discounts) + transportation charges + insurance while in transit + customs duty or similar charges + installation costs + cost of testing the asset before it is used. [After the asset is up and operating, the company no longer debits the cost of insurance, taxes, ordinary repairs and maintenance to the Equipment account. From that point on, insurance, repairs and maintenance costs are recorded as expenses. “There are many different kinds of equipment. Smart Touch has CD/DVD burning equipment. Qantas has aeroplanes and Officeworks has copiers. Most businesses have computer equipment. Furniture and fixtures Furniture and fixtures include desks, chairs, fling cabinets and display racks. The cost of furniture and fixtures includes the basic cost of each asset (less any discounts), plus all other costs to ready the asset for its intended use. For example, for a desk, this may include the costs to ship the desk to the business and the cost paid to a labourer to assemble the desk Capitalising the cost of interest Businesses sometimes construct non-current assets themselves and finance the construction borrowed money. The core principle in Accounting Standard AASB 123, Borrowing Costs, is that Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense, Directly attributable is interpreted as incurred over the period of construction. 459(CHAPTER 10NNON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES ‘A qualifying asset is one that necessarily takes a substantial period of time to get ready for its Intended use. Including interest in the asset’ total cost is called capitalising interest. To capitalise a cost means to debit an asset (instead of an expense) account. ‘On 1 January 2016, Smart Touch borrows $50000 at 10% interest to build a warehouse, The interest cost for the financial year to 30 June 2016 on this loan is $2500 ($50000 x 0.10 x 6/12). ‘The entry for the construction cost is: 2016 Jan-Jun Building (A+) 50000 Loan payable _(L+) 500000 ‘The entry to capitalise the interest is: 2016 Jun 30 Building (AW) 2500 Cash (Re) 2500 A lump-sum (basket) purchase of assets ‘A business may pay a single price for several assets as a group—a ‘basket purchase’ For example, Smart Touch may pay a single price for land and a building, For accounting purposes, it is necessary to identify the cost of each asset. This requires the total cost (100%) to be divided among the assets according to their relative fair (market) values. This allocation technique is called the relative-fair-value method. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm-length transaction. Total price What isthe What isthe ‘ofland and building cost ofthe land? cost ofthe building? eS - gan) es. dex) $100 000 H Suppose Smart Touch paid a combined purchase price of $100000 on 1 August 2015 for the land and building. A valuation indicates that the land’s market (fair) value is $30000 and the building's market (fair) value is $90000. It is clear that Smart Touch got a good deal, paying less than fair market value, which is $120000 for the combined assets. But how will Smart Touch allocate the $100.000 paid for both assets? First, calculate the ratio of each asset's market value to the total for both assets combined. The total valuation is $120000. “Land market value + Building market value $3000 + 90000 Total market value ‘The land makes up 25% of the total market value and the building 75%, as follows: Market (fair) Percentage of Total purchase Costof each Asset total value x price asset Land $30000/5120000= 25% » $1000 ' 25000 Building $90000/120000= 75% 100000 = 75.000 Total 120000 100% '$100000‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 461 For Smart Touch, the land cost $25 000 and the building cost $75.000. Suppose Smart Touch use borrowings to pay for this lump sum purchase. The entry to record the purchase of the land and building is as follows: 2015 ‘Aug! Land (4) 25000 Building (A+) 75,000 Loan payable _(L+) Capital expenditures Accountants divide expenditures related to non-current assets into two categories: + Capital expenditures + Expenses ‘Capital expenditures are debited to an asset account because they: + increase the asset's capacity or efficiency, or + extend the asset's useful life. Examples of capital expenditures include the purchase price plus all the other costs to bring an asset to its intended use, as discussed in the preceding sections, Also, the cost of a major overhaul or modification that adds to the assets capacity or useful life is a capital expenditure. An example ‘would be spending $3000 to rebuild the engine on a five-year-old truck. This major overhaul would extend the asst’ lie past the normal expected life. Asa result, its cost would be debited to the asset account for the truck as follows: Truck (At) 3.000 Cash (A+) 3.000 To.ecord cost of rebuilding the truck's engine. Expenses, such as repair or maintenance expense, are rot debited to an asset account because they merely maintain the asset in working order. Expenses are immediately matched against revenue. Examples include the costs of maintaining equipment, repairing a truck and replacing its tyres. These costs are debited to Repairs and maintenance expense, as shown in the following, ‘example, when the tyres were replaced for $500: Repairs and maintenance expense (E+) 500 Cash (A+) 500 To record the cost of tyres forthe truck Exhibit 10-3 shows some: (a) capital expenditures and (b) expenses for a delivery truck ‘Treating a capital expenditure as an expense, or vice versa, creates an accounting error. Suppose Greg's Tunes replaces the engine in the truck. This would be a capitalised repair because it increases the truck’ life. Ifthe business expenses the cost by debiting Repairs and maintenance expense ot EXHIBIT 10-3 ‘CAPITAL EXPENDITURE: EXPENSE: DEBITANASSETACCOUNT DEBIT REPAIRS AND MAINTENANCE EXPENSE Delivery truck Capitaised repairs: Ordinary repairs: expenditures— ‘Major engine or ransmission overhaul Repair of transmission or engine capital Modification for new use Oil change, lubrication and so on expenditure or [Addition to storage capacity Replacement of tyres or windshield expense? Increase the life ofthe asset Paint job462 ‘Account for depreciation EXHI Depreciation— matching of ‘expense with revenue 110-4 CHAPTER 10 NON: CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES rather than capitalising it (debiting the asset), the business would be making an accounting error. ‘This error: + overstates Repairs and maintenat + understates profit + understates owners’ equity + understates the Equipment account (asset) on the balance sheet. ce expenses Incorrectly capitalising an expense creates the opposite error. Assume a minor repair, such as replacing the water pump on the truck, was incorrectly debited to the Asset account. The error ‘would result in expenses being understated and profit being overstated. Additionally, the balance sheet would overstate the truck assets by the amount of the repair bill. The distinction between capital expenditure and repairs and maintenance is a difficult area of accounting—see Connect to Ethics (page 482). rad ee Go to Study Plan 10.1 in MyAccountingLab to test your mastery of this section Peete A eda ee a eT ct n [As we have seen, depreciation is the allocation of a non-current asset's cost to expense over useful life. Depreciation distributes the asset's cost over the time (life) the asset is used. Depreciation ratches the expense against the revenue earnt by the asset to measure profit. Exhibit 10-4 illustrates this matching of revenues and depreciation expense for a $40000 truck (numbers assumed), ‘Suppose the company believes it will get five years of service from the truck and that it will then be worth nothing, Using the straight-line depreciation method, the depreciation expense is 1/5 of the asset’s cost in each of its five years of use Causes of depreciation Allassets, except land, wear out. For some assets, wear and tear causes depreciation. Greg’ delivery truck can only go so many kilometres before it is worn out. As the truck is driven, this use is part of what causes depreciation. Additionally, physica factors, ike age and weather, can cause depreciation of assets, [Assets such as computers and software may become obsolete before they wear out. An asset is obsolete when a newer asset can do the job more efficiently. Thus, an assets useful life may be shorter than its physical life. Accountants usually depreciate computers over a short petiod— pethaps two to four years—even though the computers can be used longer. In all cases, the assets cost is depreciated over its useful life. ‘Now that we have discussed causes of depreciation, lets discuss what depreciation is not yates(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 463 1. Depreciation is not « process of valuation, Businesses do not record depreciation based on the asset's market (sales) value. 2. Depreciation does not mean that the business sets aside cash to replace an asset when it is used up. Depreciation has nothing to do with cash. Measuring depreciation Depreciation of a non-current asset is based on three factors: + capitalised cost + estimated useful ite + estimated residual value Capitalised cost is a known cost and, as mentioned earlier in this chapter, includes all items spent for the asset to perform its intended function. The other two factors are estimates, Estimated useful life isthe length of the service period expected from the asset. The estimated useful life is how long the company expects it can use the asset. Useful life may be expressed in years, output, kilometres or other measute. For example, a building’ lifes stated in years, a copier in the number of copies it can make and a delivery truck in kilometres. Estimated residual value—also called serap value or salvage value—is the aset’s expected cash value at the end of ts useful life. A delivery truck’ useful life may be 100000 kilometres, At the end of its useful life, the business will sell the truck. The expected cash receipt isthe truck’ estimated residual value. Estimated residual value is not depreciated because you expect to receive thisamount atthe end, Ifthere’s no residual value, then depreciate the Full cost ofthe asset. Cost minus residual value is called depreciable amount Depreciable amount = Cost - Estimated residual value Depreciation methods ‘There are many depreciation methods for non-current assets, but three are used most commonly: + straight line + units of production + reducing balance. (We omit the sum-of-years-digits method because very few businesses use it.) “These methods work differently in how they derive the yearly depreciation amount, but they all result in the same total depreciation over the total life ofthe asset. Exhibit 10-5 gives the data we will use for a truck that Greg’ Tunes purchases and places in service on 1 July 2013. DATA ITEM AMOUNT. Exe Cost of truck $41 000 Data for Estimated residual value (1.000) recording Depreciable amount depreciation on atruck Estimated useful fe—years, Estimated useful fe—units Straight-line method ‘The straight-line (SL) method allocates an equal amount of depreciation to each year. Greg’ Tunes right want to use this method for the truck if it thinks time is the best indicator of the truck’ depreciation. Depreciable amount is divided by useful life to determine annual depreciation. The ‘equation for SL depreciation, applied to the Greg’s Tunes’ truck, iss follows:464 EXH DATE 1-7-2013, 30-6-2014 306-2015 30-6-2016 30-6-2017 30-6-2018 (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 7 Straight-line depreciation = (Cost - Residual value) x x saaunanls tite “12 1 = (41000 = 1000) x > x = 5 2 ‘98000 per year # represents e number of months used If the asset was placed in service on the first day of the yeas, the entry to record each year’s depreciation Jun 30 Depreciation expense— truck (E+) 8000 Accumulated depreciation—truck _(CA+) 8.000 The truck was purchased on 1 July 2013, and a straight-line depreciation schedule is given in Exhibit 10-6. The final column shows the assets carrying amount, which is cost less accumulated depreciation. Carrying amount is also called book value or carrying value. At the end of its life, the asset is said to be fully depreciated. An asset’ final book valu¢ is called its residual value ($1000 in this example). Units-of-production (UOP) method ‘The units-of production (UOP) method allocates a fixed amount of depreciation to each unit of output. UOP depreciates by units rather than by years. A unit of output can be kilometres, units, hours or output, depending on which unit type best defines the asset’ use. 1 (Cos Residual value) fein units 1 (841000 - 1000). 100000 = $0.40 perkilometre “This truck in our example is estimated to be driven 20000 kilometres during the first year. 30000 in the second, 25000 in the third, 15000 in the fourth and 10000 during the fifth. The UOP depreciation for each period varies with the number of units (kilometres, in the case of the truck) T 10-6 Straight-line depreciation schedule for a truck DEPRECIATIONFORTHEYEAR 7 DEPRECIABLE DEPRECIATION DEPRECIATION ACCUMULATED CARRYING ‘AMOUNT RATE “EXPENSE DEPRECIATION AMOUNT _ i 7 Seow ik isro00-sio0 x bx = 38000 23000 : Toa, Poot ia ia tseio00-s100 x Lx B= s000 eco 25000 ee werom-sicoy x Ex 2 = ao | am 1700 1 Eee ee To a gros x bx 2 0 no 900 a ly Az eh dual termo-siooy = tx = 0mm sooo [ea‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 465 the asset produces or uses up. Exhibit 10-7 shows the UOP depreciation schedule for the Greg's “Tunes truck. Greg’ Tunes might want to use UOP depreciation for the truck ifit thinks kilometres is the best measure of the truck’s depreciation. EXHIBIT 10-7 Units-of-production depreciation schedule for a truck DEPRECIATION FORTHE YEAR ; ASSET DEPRECIATION NUMBER DEPRECIATION ACCUMULATED CARRYING ore Cost PERUNIT.”—_OFUNTS__ EXPENSE” DEPRECIATION _ AMOUNT 172613 $4000 Poorer eee ~"saveco soeaia sour x 300m Seo [8m ow e205 a i oe sons oat “j0000 3008000 wean? oa) soo 38000 ——=S0 ooze ox amo e000 «(Lae Pei *s9e previous page for $0.40 per kilometre calculation Reducing-balance method Reducing-balance depreciation is accelerated. An accelerated-depreciation method writes off more depreciation near the start of an asset’ useful life than the straight-line method does. The main accelerated-depreciation method is the reducing-balance (RB) method. Greg’ Tunes might ‘want to use this method for its tax return preparation soit could recover more depreciation in the earlier years of the truck’ use (life) and pay less taxes early on. This method multiplies the asset’s decreasing carrying amount by a constant percentage. That percentage rate is calculated as: 1- ee where N is the life of the asset in years. For the truck in Exhibit 10-5, the depreciation rate is: 1 ~ 04758204 rounded to, say, 1 - 0.476 = 0.524. (This is a simple formula for calculating the RB depreciation rate. It cannot be used when the residual value is $0, since the depreciation rate is then 100%. Very low residual values also give unrealistically high depreciation rates. More complex formulas to use in these cases are available.) ‘The RB depreciation equation is: * (Cost - Accumulated depreciation) x Depreciation rate x Reducing-balance depreciation = Ignore residual value, except for the last year. The first-year depreciation in our example is: 2 RB year = (41000 - 0) x 0524 x > or $21484466 (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES In year 2, the amount of depreciation would decline because the asset has accumulated some depreciation (the $21 484 forthe fist year). For the second year of the truck, therefore, the calculation ‘would be as shown: 2 RB, year2 = (41000 - $21484) x 0524 x -> or $10226 and so on for each year. In the RB schedule (Exhibit 10-8) the depreciation rate is applied to the carrying amount of the asset (its book value) each year (and not to its depreciable amount as in the straight-line method). Final-year depreciation isthe amount needed to bring the asset to its residual value. In Exhibit 10-8, final-year depreciation is $1 105—the carrying amount of $2 105 ess the $1 000 residual value. Ifthe depreciation rate hasnt been rounded up or down, the final year’s depreciation will be exactly equal to the depreciation rate x carrying amount at the beginning of the year (0.524 x $2105 = $1 103). However, due to rounding, these amounts may not be exactly equal. ‘The RB method differs from the other methods in two main ways: + Residual value is ignored at the start Inthe first year, depreciation is calculated on the asset’ full cost + Final-year depreciation is the amount needed to bring the asset to residual value, Final-year depreciation is a balancing figure. For practical purposes, the reducing-balance depreciation rate is sometimes taken as2 times the straight-line rate, instead of being precisely calculated. This approximation is used under Australian income tax legislation for calculating depreciation charges on many assets For our truck, the depreciation rate would be 2 x 0.20 = 0.40 (0.20 is the straight-line rate). Exhibit 10-9 shows depreciation expense for this approximation. The depreciation rate used (0.40) is only an estimate of the true reducing-balance rate (0.524), so the final year’s depreciation expense wont be equal to (0.40 x carrying amount at the beginning of the year). Note that residual value is not included in the formula, Residual value is ignored until the last year. The final year’s depreciation expense is again calculated as a balancing figure—carrying amount at the beginning of the year minus estimated residual value. In the case of the truck, residual value was given as $1000. In Exhibit 10-9, notice that, after year 4 (30-6-2017), the truck’ carrying amount is $5314. By definition, the truck is to lst five years, which ends on 30-6-2018, Also by definition, at the end of the asset life its value should equal the residual value, Therefore, in the final year, depreciation is carrying amount, $5 314, less the $1 000 residual value, or $4314 in depreciation expense. ‘Compare Exhibit 10-9 with Exhibit 10-8. Exhibit 10-9 isa rather inaccurate approximation and gives a large variation from the more precise calculation of Exhibit 10-8. Ths is especially so in the EXHIBIT 10-8 Reducing-balance depreciation schedule for a truck (with a precise depreciation rate of 0.524) DATE 1713 30-6-2014 30-6-2015 30-6-2016 30-6-2017 30-6-2018 +Last-year depreciation is the amount needed to reduce the asset carrying amount to the residual amount (52105 ~ 1000 = 1105) Due to rounding, 0.524 x $2105 does not exactly equal $1 105. RB ASSET ASSET DEPRECIATION CARRYING. DEPRECIATION ACCUMULATED CARRYING cost RATE AMOUNT _EXPENSE DEPRECIATION _ AMOUNT $41.00 A $41 000 i 0524 x «$4100 $21,484 7 19516 sax 19516 10226 9290 0524 x 4868 74422 0524 x 442 23738895 2105 0524 x 2105 1105" 40000 1000 DEPRECIATION FORTHE YEAR‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 467 1T 10-9 _Reducing-balance depreciation schedule for a truck (with approximate depreciation rate of 0.40 (2 x SL rate)) —pernecnronronrivean aa asaet BaREGHALE CERECATION, ACCUMULATED CARING ome tear Gwoune ae Sewrense™ accion AMOUNT 7519 sero ; 7] Nero i woae treo om x B= stomo | Stowe Heo a tee . seams moo oo x Ee ome mam MNO seas wm vom x Ba 5a | se seu vss cow x Z= ase ssa 4314" 40.000 1 000]+— Residual “Last year depreciation is the plug figure’ needed to reduce carrying amount tothe residual amount ($5 314 ~ $1000 = $4314), final year, due to the accumulation of errors in each of the earlier years. For income tax purposes, the final year adjustment is not made. The asset continues to be depreciated each year until its carrying amount reaches zero, or it is sold or scrapped. CONNECT TO: Taxes The diminishing-value method is the name for the Australian Tax Office's version of RB depreciation. However, the diminishing-value method uses number of days instead of proportion of months to calculate the depreciation. ee IIIa Comparing depreciation methods Lets compare the depreciation methods. Annual amounts vary, but total depreciation is $40.000 for all three methods. ‘Amount of depreciation per year _Accalaraited method. _ Year Straight line Units of production _ Reducing balance di $ 8000 '$ 8000 $16 400 2 8000 12000 9640 3 8000 10000 5904 4 8000 6000 3542 5 2000 4000 ana Total depreciation $4000 40000 $4000 Deciding which method is best depends on the asset. A business should match an asset's expense against the revenue that the asset produces. The following are some guidelines. Straight-line For an asset that generates revenue evenly over time, the straight-line method follows the matching principle. Each period shows an equal amount of depreciation. Units-of-production The UOP method works best for an asset that depreciates due to wear and. teat, rather than obsolescence. More use causes greater depreciation. For example, UOP would be appropriate for depleting natural resources, like oil or coal. UOP is also appropriate for vehicles (kilometres) and machinery (machine hours).468 stop&think (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Reducing-balance ‘The accelerated method (reducing balance) works best for assets that produce more revenue in their early years. Higher depreciation in the early years is matched against the greater revenue. For example, RB may be appropriate for depreciating computers. Comparisons Exhibit 10-10 graphs annual depreciation for the three methods: + Straight line is flat because depreciation is the same each period. + Units of production follows no pattern because depreciation varies with asset use. + Accelerated depreciation is greater in the first year and less in the later years. Think about your car. What best allocates its use? Isit the age of the car, oris it how many kilometres you drive per year? How many kilometres you drive would probably be the best measure, That is how companies should pick depreciation methods—they should work out what is the best measure to allocate the asset's cost by its use and then picka depreciation method that mirrors that use. EXHIBIT 10-10 Depreciation patterns for the various methods svaight ne Uns of reduction peclrted g g g $ 5 3 5 1 2s 4 # i 2 3 Time, in years Time, in years SUG aa Coffee-2-Go purchased a coffee drink machine on 1 January 2013 for $4000. Expected useful life is 10 years, or 100.000 drinks, and residual value is $4000. In 2013, 3000 drinks were sold and in 2014, 4000 drinks were sold. Under three depreciation methods, annual depreciation and total accumulated depreciation at the end of 2013 and 2014 are as follows: Method A Method B Method C ‘Annual Annual ‘Annual depreciation Accumulated depreciation Accumulated depreciation Accumulated Year expense _ depreciation __ expense __depreciation _expense_depreciation 2013 $1200 $1200 $8800 $8800 ‘$4000 4000 2014 5.600 6 800 7040 15840 4000 8000 Requirements 1. Identify the depreciation method used in each instance and show the equation and calculation for each method. (Round to the nearest dollar) —<—<————CHAPTER 10NNON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 2. Assume use of the same method in 2015. Show annual depreciation expense, accumulated depreciation and carrying amount for 2013 to 2015 under each method, assuming 12000 drinks were sold in 2015. Solution Requirement 1 Method A: Units of production 1000000 units 2013:$0.40 x 3000 units = $1 200 2 2 2013: ($44000- 0) x —x—~ = $8 800 10 12 2 2014: ($44 000 - $8 800) x 2 Method C:Straightline it Each year: 544000 - $4000 «> x7 02 Requirement 2 Method A: Unit of production Year Annual depreciation expense ‘Accumulated depreciation Carrying amount start ‘944000 2013 $1200 $1200 42800 2014 5.600 6800 37 200 2015 4800 11.600 32400 ‘Method B: Reducing balance: 2 times SL rate Year ____ Annual depreciation expense ‘Accumulated dey Carrying amount Start 44000 2013 $3800 $ 8800 35 200 2014 7040 15840 28 160 2015 5632 21472 22528 Method C: Straight line Year ‘Annual depreciation expense ‘Accumulated depreciation Carrying amount start 44000 2013 $4000 $ 4000 40000 2018 4000 8000 36000 2015 4000 12000 32000 Annual depreciation expense for the 3rd year, 2015: Units of production Reducing balance: 2 times St rate Straight line 469470 ‘CHAPTER 10 NON-CURRENT ASSETS:PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES, Other issues in accounting for non-current assets “There are a few additional issues to keep in mind when accounting for non-current assets, Depreciation and income taxes ‘Most businesses use straight-line depreciation for their financial statements. However, they can use a different method for income taxes. The income tax laws allow two depreciation methods, and a taxpayer may choose either. They are the ‘prime-cost’ (PC) method, which is just another name for straight-line depreciation, and the ‘diminishing-value’ method, which is the reducing-balance method using 200% (for assets held after 10 May 2006) of the straight-line (prime-cost) depreciation rate. ‘The Australian Taxation Office (ATO) publishes schedules of the effective lives of different assets from which depreciation rates can be calculated. For digital cameras the effective life is five years, so the prime-cost (straight-line) depreciation rate is 20%; for computers the effective life is four years, giving a rate of 25%. Rates can be varied by government policy, so the actual depreciation rates used may be higher than these basic rates. Suppose you manage the Virgin Blue operation at Brisbane airport. The ATO allows the reducing- balance depreciation method, and you prefer accelerated to straight-line depreciation. Why? Because accelerated depreciation provides the fastest tax deductions, decreases your immediate tax payments and so conserves cash. You can then invest the cash and earn more income. This is a common strategy. Accounting for partial-year depreciation on assets Refer to Exhibit 10-5, which provides data for Greg’ Tunes’ truck, What would happen if Greg’ places the truck in service on 1 January 2014, instead of 1 July 2013? Would the depreciation for any of the methods change? Yes, but only the methods that utilise #/12 (number of months of the year) in the formula, which means only straight line and reducing balance would change. AASB 116 states that depreciation of an asset begins when it is available for use. Units of production does not consider years in its formula; thus that calculation remains the same, however the number of kilometres travelled would be less as the truck is only in service for six months. The revised straight- line calculation under the altered in-service date of 1 January 2014 is as follows: 1 * Straight-line depreciation = (Cost - Residualvalue) x —— x ” a 7 Life "12 stb 1 6 = ($4100 - 1009) x = x — 5 oR $4000 (1 Jan-30 Jun) Since we used the asset for six monthsof the year, we only record 6/12 of straight-line depreciation expense, or $4000, in 2014. ‘Many businesses calculate partial-year depreciation by first calculating a full year’s depreciation. ‘They then multiply full-year depreciation by the fraction of the year that they used the asset. Using Gregs Tunes truck example, the calculations are as follows: ‘$41,000 - $1 000 Fullyear depreciation: = $8000 Partiat-year depreciation: $8000 x 6/12 = $4000 Here is an alternative partial-year depreci n poli + Record a full month's depreciation on assets. purchased on or before the 15th of the month, + Record no depreciation on assets purchased after the 15th ‘What if Greg’ Tunes bought the truck on 22 February? In that case you record no depreciation for February. The year's depreciation is $2667 for four months—March to June ($8000 x 4/12 = $2667).[CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Partial-year depreciation is calculated under the reducing-balance method in the same ways apply the percentage of the year that the asset is used. No special calculation is needed for the units-of-production method: simply use the number of units produced, regardless of the time for which the asset is used. Most businesses use computerised systems which automatically calculate the depreciation expense for each period. Changing the useful life of a depreciable asset Estimating the useful life of a non-current asset poses a challenge. As the asset is used, the business may change its estimated useful life. For example, Gregs Tunes may find that its truck lasts eight Years instead of five. This is a change in estimate. Accounting changes like this are common because they are estimates and, as a result, are not based on perfect foresight. AASB 116 requires that the residual value and useful life of an asset be reviewed at least annually and any changes reflected in changed depreciation rates. The details and the effects of any change in estimates must be disclosed in the financial statements (required under Accounting Standard AASB 108, Accounting Policies, Changes in Accounting Estimates and Errors). For a change in accounting estimate, the asset's remaining carrying amount (book value) is spread over the asset's remaining life (which may be longer or shorter than the original useful life). Suppose Greg Tunes used the truck purchased on 1 July 2013 for two years. Under the straight- line method, accumulated depreciation reached $16000. ccc pleemelnenieseh id DEES RER EES See De ees 1 2 Straightline deprecation for 2 years = ($4 000 ~$1 000) x—=x<—> = $8000 per year 2 years =$16000 Remaining depreciable amount (cost less accumulated depreciation ess residual value) is $2400 (541000 - $16000 ~ $1 000). Suppose Greg Tunes believes the truck will remain useful for six more years, At the start of year 3 (1 July 2015), the business would recalculate depreciation as follows: “Remaining depreciable, (New)estimated usefullife _ (New) annual depreciation, __earryingamount tem 7 2016-2021 $2400 years $4000 In years 2016 to 2021, the yearly depreciation entry based on the new useful life is: Jun 30 Depreciation expense—truck (E+) 4.000 7 Accumulated depreciation—truck (CA) 4000 Revised straight-line depreciation is calculated very much like straight the accumulated depreciation taken to date is accounted for in the foll ne depreciation, except g formula: Revised SL _ [cose _ Accumulated _ Nw |, — 1 _ gy & depreciation depreciation residual value] ~ Newremaininglife 12 Using fully depreciated assets A filly depreciated asset is one that has reached the end of its estimated useful life. No more depreciation is recorded for the asset. Ifthe asset is no longer useful, itis disposed of. But the asset ‘may still be useful and the business may continue using it, The asset account and its accumulated depreciation remain on the books, but no additional depreciation is recorded. In short, the asset never goes below residual value. eS arciasd Go to Study Plan 10.2 in MyAccountingLab to test your mastery of this section on an472 ‘Account for the disposal of a rnon-current asset by sale or exchange (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 10.3 Disposing of a non-current asset Eventually, an asset wears out or becomes obsolete. The owner may sell the asset or exchange it. If not, then itis scrapped. The overall term for this process is derecognition. In all cases, the four steps for journalising disposals or exchanges are similar and are as follows: 1 Bring the depreciation up to date. 2 Remove the old, disposed of asset from the books: a Make the Asset account equal zero by crediting the asset for its original cost b Make the Accumulated depreciation account for the asset equal zero by debiting it for all the depreciation taken to date on the asset 3 Record the value of any cash (or other accounts) paid (or received) for the asset. For example, if cash is given, credit Cash. If cash is received, debit Cash. If loan payable was signed, credit Loans payable. 4. Finally, determine the difference between the total debits and total credits made in the journal entry. Another way to determine gain or loss on the sale of a non-current is asset as follows: Gain (credit) = Sale proceeds > Carrying amount Loss (debit) = Sale proceeds < Carrying amount All gains and losses are reported in the income statement. ‘To apply this, let’s consider the truck Greg’s Tunes purchased on 1 July 2013. Assume the business recorded depreciation using the straight-line method up to 30 June 2015. According to Exhibit 10-6 presented earlier in the chapter, Greg’s Tunes’ historical cost of the truck was $41000, $1000 was the estimated residual value and $16000 has been recorded in total accumulated depreciation up to 30 June 2015, Before we consider any transactions, the T-accounts would appear as follows Truck Accumulated depreciation—truck “41000 16000 To illustrate accounting for disposal of an asset, lets consider three options that Gregs Tunes has to dispose of the truck. All options are assumed to take place on 30 September 2015. Separate exhibits illustrate each of the three options. 1 Situation A—"The truck is in an accident and is destroyed. The truck is completely worthless and ‘must be scrapped for $0, There are no insurance proceeds from the accident. 2 Situation B—Greg’s Tunes sells the truck to Bob’ Burger House for $1000 cash, 3 Situation C—Greg’s Tunes trades the old truck in for a new Toyota truck. The fair market value of the Toyota truck is $32000, Situation A—scrap the truck If assets are scrapped before they are fully depreciated, there is a loss equal to the asset's carrying amount. Let’ apply the four steps for disposal outlined previously to demonstrate this: STEP 1: Bring the depreciation up to date. Depreciation has not been taken on the truck since 30 June 2015. It is now 30 September 2015, so three months have passed and we need to record three months of depreciation. The problem stated earlier that Greg’ is using the straight-line method, so we calculate depreciation for the three months and journalise. STEP 2: Remove the old, disposed of asset from the books. To remove the asset, we must zero out both the asset and Accumulated depreciation accounts. (Note that the entry is incomplete at this point because we must record what we have received, if anything, in the next step.) STEP 3: Then record the value of any cash (or other accounts) paid or received. Since Greg Tunes received $0 for the scrapped truck, there is nothing to add to our disposal entry we are building from step 2.(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES STEP 4: Finally, determine the difference between the total debits and total credits made in the journal entry. Total debits are $18 000 and total credits are $4100. Credits > Debits, so ‘we must record a debit for the difference, of $23000 ($41 000 - $18 000). This is a loss on disposal because we received nothing for the truck that had net carrying amount (Cost - Accumulated depreciation) of $23 000. step 1 2015 Depreciation expense (E+) 2000 sep 30 ‘Accumulated depreciation (CA+) 2000 {141 000 Cost ~ 1 000 Residual value) x 1/5 yr 3/12] Steps 2,34 ‘Accumulated depreciation (16000+2000) (CA-) 18000 Losson disposal oftruck (E+) 23000 Truck ww Situation B—sell the truck for $10000 Considering the same facts for Greg’ Tunes, lets apply the four steps for disposal outlined previously to demonstrate this situation: STEP 1: Bring the depreciation up to date. This is identical to what we journalised in Situation A. STEP 2: Remove the old, disposed of asset from the books. To remove the asset, we must zero out both the asset and Accumulated depreciation accounts. (Note that the entry is incomplete at this point.) STEP 3; Then record the value of any cash (or other accounts) paid or received. Since Greg’ Tunes received $10000 for the truck, we must add that cash to our entry. ally, determine the difference between the total debits and total credits made in the journal entry. Total debits are $28000 ($10000 + $18000) and total credits are $41 000. Credits > Debits, so we must record a debit for the difference, or $13000 (41000 - $2800). This isa loss on sale. Step 1 2015 Depreciation expense (E+) 2.000 Sep 30 ‘Accumulated depreciation (CA+) 2000 [141 000 Cost - 1 000 Residual value) x 1/5 yr3/12] Steps 2,3,4 Cash (A) 10000 ‘Accumulated depreciation (16000 +2000) (CA-) 18000 Loss on sale of truck (E+) 13.000 Truck_(A-) Situation C—exchange the truck for a $32000 Toyota truck Businesses ofien exchange old non-current assets for new ones. A common exchange is a trade- in. Considering the same facts for Greg’ Tunes, lets apply the four steps for disposal outlined previously to demonstrate this situation: STEP 1: Bring the depreciation up to date. This is identical to w! STEP 2: Remove the old, disposed of asset from the books. To remove the asset, we must zero out both the asset and Accumulated depreciation accounts, (Note that the entry isincomplete at this point.) STEP 3: ‘Then record the value of any cash (or other accounts) paid or received. Greg did not receive cash. He received a new Toyota truck. Since the value of the new Toyota truck is known to be $32000, we must record the new Toyota truck at its fair value of $32000. STEP 4: Finally, determine the difference between the total debits and total credits made in the journal entry. Total debits are $50000 ($18 000 + $3200) and total credits are $41 000. Debits > Credits, so we must record a credit for the difference, or $9000 ($50000 - ‘$41 000). This is @ gain on sale 1 we journalised in Situation A. 473ama ‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Step 1 2015 Depreciation expense (E+) 2000 Sep30 Accumulated depreciation (CA) 2000 [141 000 Cost ~ 1 000 Residual value) x 1/5 yr 3/12], steps2.3,4 ‘Accumulated depreciation (16 00042000) (CA-) 18000 ‘Truck (Toyota) (At) 32000 Truck (A+) 41.000 inon exchange of truck (Rt) 9.000 Note: The gain or loss on sale is an offset of the carrying amount and proceeds of sale. In general, offsets are not allowed under Australian Accounting Standards but AASB 101 justifies the treatment ‘on the basis that sale of property, plant and equipment assets is not a main revenue generating activity of the business. Internal control of non-current assets Internal control of non-current assets includes physically safeguarding the assets and having an adequate record system. Suppose the head office and senior managers of a business are in Sydney but the business has a factory in Melbourne that produces pumps. The managers rarely visit the factory and therefore cannot control non-current assets by on-the-spot oversight. What features does their internal control system need? Safeguarding non-current assets includes: 41. assigning responsibility for custody ofthe assets separating custody of the assets from accounting for the assets (this separation of duties is a ‘cornerstone of internal control in almost every case) setting up security measures—such as security patrols and restricted access rules—to prevent theft protecting assets from the weather (rain, hail and so on) having adequate insurance against fire, storm and other losses training operators in the proper use of the assets keeping a regular maintenance schedule. Non-current assets are controlled much like high-priced inventory is controlled—through subsidiary records. Businesses use an asset register to do this. A control record describes each non current asse, its location and the employee responsible for it. The control record can also show the asses cost, useful life and other accounting data. Exhibit 10-11 is an example for our pump factory. “The asset register can provide the data for calculating annual depreciation and recording accumulated depreciation. ‘The asset purchase cost ($190000) and accumulated depreciation (645.000) added together forall assets of the same class should agree with the balances in the general ledger accounts (such as Machinery and Accumulated depreciation—machinery). Impairment of non-current assets Accounting Standard AASB 136, Impairment of Assets, requires that, ifthe carrying amount of an asset is greater than its ‘recoverable amount, then the carrying amount must be reduced (‘written down’) to that recoverable amount. The Standard applies to all assets but mainly relates to non ‘current assets. Recoverable amount is the higher of an asset's market selling value and its value in use. “Value in use’ means the cash flows expected to be gained from using the asset, discounted to their present value. The amount of the write-down, an ‘impairment loss, is an expense and is included in the income statement. In effect, you suffer a loss if an asset can no longer deliver the benefits it was originally expected to provide. ‘Suppose that some land, a non-depreciable asset, which cost $100 000, is now believed to have a recoverable amount of only $80000, The entry to record this loss on the write-down of the land is: Impairment loss onland (E+) 20000 Land _ (A 20000(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES EXHIBIT 10-11 ‘Asset Milling machine Location Melbourne factory—pump section Employee responsible forthe asset Department manager ost $190000 Purchased from Boone Suppl Depreciation method SL Usefullife 1oyears Residual value _$10000 General ledger account Machinery 475 Asset register ; asuAAT Asset |____ ACCUMULATED DEPRECIATION DATE EXPLANATION” DEBT cREDTT——=CBAL| EDIT. CREDIT. BAL, 34ul2D13 Purchase 790000 790000" | 3162013 Deprec 2000 9000 31Dec 2014 Deprec. | 18.000 27000 | 18000 45000 31 Dec 2015 __Deprec._ For depreciable assets, itis usual for accumulated depreciation to be first credited against the asset. A building with a carrying amount of $150000 (original cost, $200000, less accumulated depreciation, $50000) has a recoverable amount of only $120000. The building must therefore be ‘written down by $30000 ($150 000 - $120000), The entries to record this are: 30000 Impairment oss on building (EH) ‘Accumulated depreciation—building (CA-) 50.000 Building (A-) 80000 To record the impairment ‘An alternative is simply to credit an Accumulated impairment loss account. This is similar to an Accumulated depreciation account. AASB 136 allows the use of one accumulated depreciation and impairment losses account. In this case, there would be only one simple entry: Impairment oss on bulding (E+) 30000 ‘Accumulated impairment loss—bullding (Ci 30000 Future depreciation charges are based on the new carrying amount ofthe asset. The new carrying amount is the $120000 recoverable amount of the asset in both cases. Examples of indicators of impairment {2} Cessation of the demand or need for services provided by the asset [Aschool closed because of a lack of demand for school services arising from a population shift to other areas. It is not anticipated that this demographic trend affecting the demand for the school services will reverse in the foreseeable future. {b) Significant long-term changes in the technological environment ‘Medical diagnostic equipment is rarely or never used because a newer machine embodying more advanced technology provides more accurate results. (0 Significant long-term changes in the legal or government policy environment ‘Acar does not meet new emission standards or a plane does not meet new noise standards. (@) Evidence is available of physical damage of an asset ‘building damaged by fire or flood or other factors. uo}}2e UT $1d33NO)476 (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPNENT, AND INTANGIBLES icant long-term changes in the extent to which an asset is used, oris expected to be used ‘A mainframe computer that is underutilised because many applications have been converted or developed to operate on servers or PC platforms. {f) Significant long-term changes in the manner in which an asset is used, or is expected to be used ‘A school building that is being used for storage rather than for educational purposes. (g) Evidence that indicates that the service performance of an asset is, or will be, significantly worse than expected ‘An internal health department report on operations of a rural clinic may indicate that an x-ray machine used by the clinic is impaired because the cost of maintaining the machine has significantly exceeded that originally budgeted. Source: Appendix 72: Examples of Indicators of Impairment, adapted extracts from Non-Current Asset Policies for the (Queensland Public Sector, Chapter 7—impairment of Assets, January 2010, sourced from: cwwwseasury.id.govau/ ffce/knowledge/docs/non-current-asset-polcies/non-curtent-asset-polcies-07.pdf>, Queensland Govern ent Treasuy, p.10-12 QUESTIONS TO THINK ABOUT 1 Doallof these examples seem reasonable as indicators ofimpairment? 2. Can you suggest some further examples that might be relevant for each of the categories listed? 3. These examples are taken from a government source. Would they be equally applicable to private businesses? Ifnot, what alternative indicators would be appropriate? ee accused rR Go to Study Plan 10.3 is MyAccountingLab to test your mastery of this section SSC Ud ‘Account for the revaluation of non-curtent asset ‘A modification to the cost principle (the recording of assets at their original cost) is that Accounting Standard AASB 116, Property, Plant and Equipment, allows businesses to record non-current assets using either the cost model or the revaluation model. The revaluation model records the asset atts fair value. Fair value means the amount for which an asset could be exchanged between knowledgeable, willing parties in an armis-length transaction. It is the market value of the asset. All the individual assets in a particular clas (such as land, or buildings, or plant and equipment) must be recorded on the same basis, at either cost or fair value. Assets recorded at fair value must be revalued regularly to ‘ensure that the carrying amount of each asset is maintained at its current fair value. ‘A revaluation can increase the carrying amount of an asset (a revaluation increment) or can decrease its carrying amount (a revaluation decrement), The most common asset to be revalued upwards is land; the next most common is buildings. Plant and equipment are less likely to be revalued upwards because they usually have shorter useful lives and are much more likely to decrease in value than to increase. They are more likely to have carrying amounts reasonably close to their market values. ‘Use of the revaluation (fair value) model is optional. You may choose to revalue non-current assets or retain the cost model for recording them, However, the choice must be based on provision of useful information to users of financial statements. Disclosure requirements Businesses using the revaluation model must disclose the date of the revaluation, the methods used to estimate fair values and whether valuations have been made by management or by an independent valuer,(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES [AASB 116 requires that a revaluation increment must be credited directly to owners! equity (by crediting a Revaluation surplus account), except that when it reverses a previous downward revaluation itis creditedas revenue in the income statement. A revaluation decrement mustbe debited as an expense in the income statement, except that when it reverses a previous upward revaluation it is debited to the Revaluation surplus account. Even though all the assets in a particular class must be revalued at the same time, revaluation increments and decrements must be treated separately for ‘each individual asset. Revaluation increases and decreases must not be offset against each other even within a class of assets (except in the case of not-for-profit entities—such as recognised charities— that do offset revaluation increases and decreases within each class of assets). When an asset is revalued, accumulated depreciation can be treated in either of two ways. ‘Accumulated depreciation can be credited against the asset and the net balance of the asset then increased or decreased by the amount of the revaluation. We will use this method in our examples, since itis simple and straightforward. (The alternative isto increase or decrease both the asset and its accumulated depreciation proportionately so that the net carrying amount of the asset equals its revalued amount.) Under either method, future depreciation charges will be the same. The carrying amount of the asset must still be depreciated over its remaining useful life. Any gain or loss on the disposal of an asset is based on the revalued carrying amount. Suppose some land, a non-depreciable asset, which cost $100 000 is revalued to $200000. The entry for this is: Land (AY) 100000 Revaluation surplus (E+) 100.000 For depreciable assets, first credit accumulated depreciation against the asset. A building with an original cost of $200000 and accumulated depreciation of $50000 is revalued to $400 000. Its carrying amount before revaluation is $200000 - $5000 = $150000. The building is therefore revalued upwards by $250000 ($400000 - $150000 carrying amount). The entries are: Accumulated depreciation—building (CA-) 50000 Building (A-) 50000 Building A) 250000 ee, Revaluation surplus For a revaluation decrement, ASB 116 requires that the write-down be accounted for as a loss unless the asset has previously been revalued upwards. In this case, any write-down, up to the amount of the previous revaluation, is charged against the Revaluation surplus account. ‘Assume the building in the previous example, with a carrying amount of $1500000 (cost $200 000 less accumulated depreciation $50000), is revalued downwards by $30000 to a value of $120000. ‘The entries to record this are: ‘Accumulated depreciation—building (CA-) 50000 Building (A-) 50.000 Loss on revaluation of building (E+) 30000 Building “a IM this building had originally cost only $130000 and been revalued upwards at some earlier time by $70.000, the entries to record its current downward revaluation would be: ‘Accumulated depreciation—building (CA-) 0.000 Building (A-) 50000 Revaluation surplus (E-) 30000 Building (A-) 477a8 Account for natural resources (CHAPTER TONON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES. “The debit of $300000 to the Revaluation surplus account now partly offsets the $70 000 previously credited to the surplus account. Finally, to record disposal of a revalued asset (termed derecognition), assume the land which cost $100 000 and was revalued to $200000 is sold for $250.000. The relevant entries are: Cash (A+) 250.000 Land (A+) 200.000 Gain on sale of land_(R+) 50000 In practice, the entries for revaluations are likely to be more complicated than we have shown, ‘This is because of the need to allow for any income tax effects of asset revaluation in accordance with Accounting Standard AASB 112, Income Taxes. Praca ac hy eC Go to Study Plan 10.4 in MyAccountingLab to test your mastery of this section 10.5 Accounting for natural resources Natural resources are non-current assets that come from the earth. Natural resources are like inventories in the ground or on top of the ground. Examples include iron ore, oil, natural gas, diamonds, coal and timber. ‘The resources and energy sectors are very important to the Australian economy, as the value of exports of natural resources soared 27% to a record $175 billion in the 2010/11 financial year. Resources underpin important sections of the industrial and export activity, making them critical to the Australian economy. The mining sector has performed strongly over the past decade and has made a significant contribution to government budgets. Minerals and resources extracted in ‘Australia include iron ore, uranium oxide, iron and steel, aluminium, gold, thermal and metallurgical coal and nickel. Natural resources are expensed through depletion. Depletion expense is that portion of the cost of natural resources that is used up in a particular period. Its called depletion because the company is depleting (using up) a natural resource such that, at some point in time, there is nothing left to dig out ofthe ground, Depletion expense is calculated by the units-of-production formula: 1 (Cost -Residual value) x Estimated total units of natural resources Depletion expense (UOP) Number of units removed {An oil well may cost $700 000 000 to bring into production and hold 70000000 barrels of cil Natural resources usually have no residual value. The depletion rate, as a result, would be $10 per barrel {($700000000 - 0) x 1/700000000 barrels). If 3000 barrels are extracted during the month, then depletion expense for that month is $30.000 (3000 barrels x $10 per barrel). The depletion entry at the end of the month is as follows: Depletion expense (3000 borels $10). (E¥) 30000 Accumulated depletion—oll_(CA+) 30000 14500 barrels are removed next month, depletion expense is $45000 (45 barrel). ‘Accumulated depletion is a contra account similar to Accumulated depreciation. Natural resources can be reported on the balance sheet as shown for oil in the following example: \0 barrels x $10 per‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 479 Property, plant and equipment: Land $ 40000000 Buildings $ 90000000 Equipment 20000000 100000000 Less: Accumulated depreciation 30000000 70000000 on 700000000 Less: Accumulated depletion 75000 699925000, Property plant and equipment net : : 5809925000 eee. «cured Go to Study Pla 10.5 in MyAccour SUR ee Re CU od fo) ‘As we saw earlier, intangible assets have no physical form. Instead, these assets convey special rights _Account for from patents, copyrights, trademarks and so on. These types of intangible assets can be individually intangible assets identified and recognised. Goodwill is an intangible whose value comes from assets that cannot be «+++ eee eeee separately identified. We look at goodwill a litle later in this chapter. In our technology-driven economy, intangibles are very important. Consider online pioneer ‘Bay. The firm has no physical products or equipment, but it helps people to buy and sell everything. from Batman toys to old picture frames. Each month, eBay serves millions of customers. In a sense, eBay is a business of intangibles. “The intellectual capital of eBay or Intel is difficult to measure. But when one business buys another, we get a glimpse of the value of the acquired firm. For example, Microsoft Corporation acquired internet phone service Skype for US$8.5 billion for Skype’ net tangible assets of around 'USS287 million? Why so much for so little? Because Microsoft values Skype’ intangible assets in the billions. Intangibles can account for most of a firms market value, so businesses must recognise their intangibles, just as they do inventory and equipment. ‘A patent is an intangible asset that protects a secret process or formula. The acquisition cost of 4 patent is debited to the Patents account. The intangible is expensed through amortisation, the systematic reduction of the asset’s carrying amount on the books. Amortisation applies to intang- ibles exactly as depreciation applies to tangible non-current assets such as equipment. Depreciation and amortisation are conceptually the same. \gLab to test your mastery of this se Climate change—accounting implications Over the past 12 to 18 months, global warming has dominated political, economic and legal debate. Climate change-related trends that will alter workplaces, careers, business and management over the next few years are emerging. When | started writing about it years ago, | was told it was a marginal, and most definitely a non- business, issue. Now it has become one of the most prominent matters in business leaders’ minds ... Questions about the ownership of emissions—try working that out in a complex manufacturing ‘process—and how they are costed and accounted for are stil to be resolved. = a a yi 7ST Cu480 (CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Carbon credits are intangible assets that raise the sorts of questions that keep accounting specialists Lup at night. How do you value a carbon credit? Does it have an historic value, or is it based on market conditions? Does it have a listed market value, or do you just get a bunch of players together, throwing darts at a board and sticking their own price on it? Is the carbon credit part of the company's general operations, orisit an asset in its own right? And how do you account for any diminution in value? Does it go into a revaluation reserve in the equity section on the balance sheet, or does it hit the bottom line on the P&L? All of this is stil to be worked out. ‘As with forces such as globalisation and technology, the changes created by global warming are still ‘emerging, But they are here to stay. Source Leon Getter, "Globally warming to global warring; Te Age, 27 November 2007, . Adapted with permission. Amortisation is calculated over the asset’s estimated useful life—usually by the straight-line method. Obsolescence is the most common reason an intangible’ useful life is shortened from its expected length. The residual value of most intangibles is zero, ‘Some intangibles have indefinite lives. For them, the business records no systematic amortisation cach period. Instead, it accounts for any decrease in the value of the intangible as an impairment. Specific intangibles Patents, copyrights, trademarks and franchises are intangible assets. Their accounting follows the pattern we illustrate for patents. Patents {A patent is a government grant conveying an exclusive 20-year right to produce and sell an inven tion. Like any other asset, a patent may be purchased. Suppose Greg’s Tunes pays $200000 to acquire a patent on 1 july 2013, Greg’ Tunes believes this patent's useful life is only five years because itis likely that a new, more efficient process will be developed within that time, Amortisation ‘expense is therefore $40000 per year ($200000/5 years). Acquisition and amortisation entries for this patent are: 2013 Jul Patents (A+) 200000 Cash (A-) 200000 To.acquirea patent. 2018 Jun 30 ‘Amortisation expense—patents (5200 000/5) (E#) 40.000 Patents (A-) 40000 To.amortse the cost ofa potent. Atthe end of the first year, Greg's Tunes will report this patent at $160.000 ($200000 minus first- year amortisation of $4000), next year at $120000 and so on. Each year for five years the value of the patent will be reduced until the end of its five-year life, at which point ts net carrying amount will be $0. Copyrights [A copyright is the exclusive right to reproduce and sell a book, musical compos ‘work of art or intellectual property. Copyrights also protect computer software programs, such as ion, film or other(CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Microsoft Windows™ and the Excel spreadsheet software. A copyright extends 70 years beyond the author’ life. ‘A business may pay a large sum to purchase an existing copyright. For example, « publisher ‘may pay $1 million for the copyright on a popular novel. Most copyrights have short useful lives Trademarks, brand names ‘Trademarks and trade names (or brand names) are assets that represent distinctive products or services, such as the Nike ‘swoosh, They can be famous names, slogans or symbols. Apple and Coca Cola and Vegemite are famous brand names, The ‘target’ symbol is the trademark for Target stores around Australia. Legally protected slogans include Avis Rental Cars'‘We try harder. The cost of a trademark or trade name is amortised over its useful life. Franchises, licences Franchises and licences are privileges granted by a private business or a government to sell pro- ducts or services under specified conditions. McDonald's and Boost Juice are well-known business franchises. The acquisition cost of a franchise or licence is amortised over its useful life. Accounting for goodwill Goodwill is a truly unique asset. In accounting, goodwill is the excess of the cost to purchase another business or its net assets over the market value of its net assets (assets minus liabilities) Goodwill is the value paid above the net worth of the business’ assets and liabilities. Many factors can give rise to goodwill, such asa superior management team, loyal and efficent employees, long- standing customers or a strategic location. ‘Goodwill refers to the benefits arising from all such factors jointly and it is impossible to measure the benefits arising from them individually. Internally ‘generated goodwill is built up by a business over its life, Itis usually impossible to identify particular ‘vents or transactions that contribute to the overall goodwill of a business. Nor can its value be measured reliably. Accounting Standard AASB 138, Intangible Assets, therefore states that internally generated goodwill shall not be recognised as an asset. ‘Accounting Standard AASB 3, Business Combinations, describes what is called purchased ‘goodwill Iti the excess of the cost to purchase another business over the fair (market) value ofits identifiable net assets (assets minus liabilities). Suppose Woolworths has expanded in Tasmania and acquired Tasman Stores. The sum of the market values of Fasmanis assets was $9 million and its liabilities totalled $1 million, so Tasman’s net assets totalled $8 million. Suppose Woolworths paid $10 million to purchase Tasman Stores, In this case, Woolworths paid $2 million for goodwill, calculated as follows: Purchase price to acquire Tasman Stores {$10 000.000 Fair (market) value of Tasman Stores assets +$9.000000 Less: Tasman Stores liabilities (1.000000), Fair (market) value of Tasman Stores’ net assets Excess called goodwill Woolworths’ entry to record the purchase of Tasman Stores, including the goodwill that Woolworths purchased, would be: ‘Assets (Cash, Receivables, Inventory, Equipment and any other assets, including any identifiable intangibles, all at fair value) 9.000.000, Goodwill 2.000000 Liabilities 1,000 000 Cash 110.000 000 Purchased Tasman Stores. 481‘CHAPTER 10 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES Goodwill has some special features: 4+ Goodwill is recorded only by a business that purchases another enterprise, An outstanding reputation may create goodwill, but that enterprise never records goodwill for its own business. Instead, goodwill is recorded only by the acquiring entity when it buys another enterprise. 2. The acquiring business measures the current value of its goodwill each year. Ifthe goodwill has, increased in value, there is nothing to record. But if goodwills value has decreased, then the business records an impairment loss as required by AASB 136 and writes down the goodwill For example, suppose Woolworths’ goodwill—purchased above—is worth only $1 500000 at the ‘end of the first year. In that case, Woolworths would make this entry: 2014 7 Jun 30 Impairment oss on goodwill (E+) 500 000 ‘Goodwill ($2,000 000 - $1 500000) (A-) +500 000 Recorded impairment loss on goodwill. ‘Woolworths would then report this goodwill a its current value of $1 500 000. Negative goodwill, or excess on acquisition “There can be cases where ‘negative goodwill’ (or gain on bargain purchase) arises—when the fair value of net assets acquired exceeds the cost of their acquisition. This can be scen as a bargain purchase. AASB 3 requires that the values of the assets and liabilities acquired and! the cost of the acquisition be checked to see if any measurement errors have occurred. If there is no error and there has truly been a bargain purchase, then it is recorded as a gain in the income statement. Accounting for research and development costs Accounting for research and development (R&D) costs has been one of the harder issues the accounting profession has faced. R&D is the lifeblood of businesses such as Sigma Pharmaceuticals, CSL, Intel and Boeing, because itis vital to the development of new products and processes. But, in general, businesses report litte if anything for these assets on their balance sheets. "AASB 138, Intangible Assets, requires businesses to expense research costs as they are incurred. Development costs can be recognised as an asset only in very limited circumstances when a number of restrictive tests are all met. CONNECTTO: Accounting standards e AASB 138 is consistent with IAS 38, Intangible Assets, which requires development costs to be capitalised only after technical and commercial feasibility of the asset has been established. This means that, if the business intends to be able to complete the research and development portion (that is, complete the asset) and either use it or sell it, then the business must be able to demonstrate how the asset will benefit future periods. If the business can demonstrate this, then developmental costs would be capitalised as an asset. CONNECT TO: Ethics e The main ethical issue in accounting for non-current asset whether to capitali ‘or expense a cost. In this area, businesses have split personalities. On the one hand, they want to save on taxes. This motivates them to expense all costs and decrease taxable income. But they also want to look as good as possible, with high net profit and high assets.(CHAPTER 10 NON-CURRENT ASSETS:PROPERTY, PLANT AND EQUIPMENT, AND INTANGIBLES 483 In most cases, a cost that is capitalised or expensed for tax purposes should be treated the same way in the financial statements. What, then, is the ethical path? Accountants should follow the general guidelines for capitalising a cost: Capitalise all costs that provide a future benefit. Expense all other costs. Many businesses have got into trouble by capitalising costs that were really expenses; they made their financial statements look better than the facts warranted, WorldCom in the USA committed this type of accounting fraud on a huge scale, and its former top executives served prison terms as a result. There are very few cases of businesses ; ; , accessed 22 November 2011. 2. Source: Skype IPO documents available from: and Reuters: , accessed 22 November 2011.