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Introduction
Depreciation is something we all know about. We buy something today, and it is not worth the same tomorrow. Some things depreciate faster than others. Cars and computers gener- ally depreciate much faster than our other assets. The Companies Act requires companies to make a charge for depreciation in their accounts to reflect the shrinking in value of their assets. The original cost of the asset is spread over its useful life to match the costs of the asset to the benefits that it has generated. This depreciation charge is not a cash cost to the busi- ness. (We do not pay depreciation in the same way that we pay rent; we physically pay depre- ciation when we trade our car in. That is when we find that it is not worth what we paid for it.)
The company’s definition of costs (how much should be capitalised and charged to fixed assets), and their depreciation policy affects both the profitability of the company and the value of the assets shown on the balance sheet. Capitalising costs and extending asset lives can flatter both profits and net worth, and should always be spotted by the analyst.
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What should we depreciate?
In the UK most fixed assets must be depreciated, the only exceptions are:
(1) Investment properties
These are stated at market value and not depreciated under UK accounting standards (SSAP 19,Accounting for Investment Properties). An investment property is one that is:
Government grants should only be recognised when it is likely that the company will comply with the conditions relating to the grant and will therefore receive the grant. In the UK, government grants are regarded as deferred income and include its creditors on the balance sheet. They are then credited to the profit and loss account over the life of the asset. This accounting treatment may not be followed overseas, but the different practices will have little impact on the reported profitability.
SUMMARY
● held for its investment potential;
● having rental income determined on an arm’s length basis;
● not occupied by the company or any other member of the group.
They are not depreciated as it is felt that depreciating an asset that is being used directly to generate income would be illogical! Only permanent falls in the value of investment prop- erties would be charged to the profit and loss account under the proposals in FRED 9 (Amend- ment of SSAP 19, Accounting for Investment Properties). However, SSAP 19 represents a departure from the Companies Act requirement to depreciate any fixed asset that has limited useful economic life. Consequently, companies usually note in their accounts that this departure is necessary for a ‘true and fair view’.
(2) Land
This should only be depreciated if there is a permanent fall in its value that is below its book value.
All other assets must be depreciated, although some retailers do not depreciate shops.
(They will be unable to continue with this policy if the proposals in FRED 17 become a stan- dard.) This and the note for investment properties is illustrated by Extract 8.1 from the accounting policies in Marks & Spencer’s 1997 accounts:
The UK accounting practice of not depreciating investment properties runs contrary to the Fourth Directive’s instructions, and is not found anywhere else in the EU. Similar treatment is allowed under international accounting standards. Investment properties may be treated as ordinary properties or classified as investments and covered under IAS 25 (Accounting for Investments), which permits periodic revaluation (although not necessarily annual) and, therefore, no depreciation. In the USA depreciation should be provided on all assets except land, whereas in Canada all fixed assets should be depreciated. Japan has no special treat- ment for investment properties.
8 Depreciation of assets
FIXED ASSETS b Depreciation
…
(ii) Given that the lives of the Group’s freehold and long leasehold properties are so long and that they are maintained to such a high standard, it is the opinion of the directors that in most instances the residual values would be suffi- ciently high to make any depreciation charge immaterial. The directors have based their estimates of residual values on prices prevailing at the time of acquisition or revaluation. Where residual values are lower than cost or valuation, depreciation is charged to the profit and loss account. Any permanent diminution in value is also charged to the reval- uation reserve or the profit and loss account as appropriate.
c Investment properties
Investment properties are revalued annually and are included in the balance sheet at their open market value. In accor- dance with SSAP 19, no depreciation is provided in respect of investment properties. This represents a departure from the Companies Act 1985 requirements concerning the depreciation of fixed assets. These properties are held for investment and the directors consider that the adoption of this policy is necessary to give a true and fair view.
FIXED ASSETS (MARKS & SPENCER) Extract 8.1
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How should we depreciate?
The depreciation charge should take account of the asset’s:
● cost
● life
● net residual value (the scrap value, at the end of its life).
If an asset’s value has fallen permanently, the Companies Act requires that it should be shown at its new value. This is called a permanent diminution. SSAP 12 requires that the assets should be written down immediately to the estimated recoverable amount, and any associ- ated depreciation charged to the profit and loss account. The recoverable amount can then be written off over the remaining life of the asset, in the normal way.
FRED 17 (Measurement of Tangible Fixed Assets) states that ‘the fundamental objective of depreciation is to reflect in operating profit the cost of using the assets (i.e. amount con- sumed) that generate the revenue in the period’. There are several ways that companies can do this and the different depreciation methods are illustrated in the example below.
A company buys a machine for £10 490, which it believes will last for five years and have a scrap value of £490 in five years’ time.
The straight-line method
The company has £10 000 to depreciate over five years, and would make an annual charge to the profit and loss account of £2000 (10 000 5). This is the most popular method of depreci- ating assets in the UK.
The depreciation charge is constant at £2000 per year and the value of the asset is decreas- ing in a straight line:
Depreciation Asset value
£ £
1st year 2000 8490
2nd year 2000 6490
3rd year 2000 4490
4th year 2000 2490
5th year 2000 490
Whilst this is the most common method, it is not the only method of depreciating assets.
There are many other methods that companies can use, and the main ones are illustrated below.
Reducing balance
This is also called the declining-balance method. It uses a fixed percentage each year and applies this to the diminishing value of the asset. The percentage is calculated by using the following formula, which will give the chosen residual value at the end of the chosen life.
1– n residual value cost (nis the anticipated life).
Using the example above, the percentage that would be used is 45.8 per cent, and this would give the following depreciation charges and asset value:
√
EXAMPLE
Depreciation Asset value
£ £
1st year (10 490 x 45.8%) 4805 5685
2nd year (5 685 x 45.8%) 2604 3081
3rd year (3 081 x 45.8%) 1411 1670
4th year (1 670 x 45.8%) 765 905
5th year (905 x 45.8%) 414 491
(rounding error of 1) Do not let the formula fool you. Although there is a root sign in it, it is no more accurate than any other way of calculating depreciation. All it does is calculate the percentage that would allow us to arrive at what, for UK companies, is a purely arbitrary residual value. Some companies prefer the reducing-balance method, as they believe it gives a closer approxima- tion to ‘real’ depreciation. However, as many UK companies write assets down to zero, the reducing-balance method becomes almost impossible to use. (Try calculating the percentage when the residual value is zero!) Plus, there are problems with this method if there are small residual values. The method gives unrealistically high charges in the early years.
Sum of the digits
In the UK this method is usually used by leasing companies, but it is more widely used over- seas, particularly in the USA. It gives a depreciation charge that falls between the straight- line method and the reducing-balance method. The sum of the digits is simply the total of the number of years the asset is expected to last (1 + 2 + 3 + 4 + 5 = 15) and can be found quickly by using the formula:
n(n + 1) 2
(nis the anticipated life).
Having found the sum of the digits, the next step would be to find the depreciation factor for each year. In the first year depreciation is calculated at 5/15 x £10 000, in the second 4/15 x
£10 000 and so on:
Depreciation Asset value
£ £
1st year (5/15 x 10 000) 3333 7157
2nd year (4/15 x 10 000) 2667 4490
3rd year (3/15 x 10 000) 2000 2490
4th year (2/15 x 10 000) 1333 1157
5th year (1/15 x 10 000) 667 490
Some companies prefer this method as it reflects ‘real’ depreciation, but is not as extreme as the reducing-balance method.
Usage-based method
All of the depreciation methods discussed above are fairly arbitary. Some companies use a depreciation method that is based on the use of the asset, as this more directly relates the cost of the asset to the sales and production in an accounting period. This method expresses the life of the asset as production units, or hours, rather than years. It is often used for machinery and planes.
8 Depreciation of assets
Continuing our example, if the company believed that the machine would last for 20 000 hours, the annual depreciation charge would be based on the usage, at 50p an hour.
Usage Depreciation charge Asset value
(hours) £ £
1st year 3 600 1 800 8 690
2nd year 4 800 2 400 6 290
3rd year 3 600 1 800 4 490
4th year 2 800 1 400 3 090
5th year ..5.200 ..2.600 490
20 000 10 000
The annuity method
This method takes account of the cost of capital tied up in the asset. The objective is that both the interest and the cost of capital should be constant. Consequently, when the asset is new, the debt and interest will be high and the depreciation will be low. It may be approp- riate for large fixed assets that are funded externally, and is occasionally used to write off the premium on leasehold properties over the period of the lease.
The annual depreciation charge is calculated by using present-value techniques and annu- ity tables. (If you are unfamiliar with the principles of present value, they are explained in detail in the introduction to discounted cash flow chapter in Appendix I.) This method can be criticised on two grounds:
(1) it is hard to understand why the depreciation should be linked to the way that the asset has been financed;
(2) it would appear to be imprudent, as it assumes future profitability.
UK companies give limited information on their depreciation policies, as the extract below from the accounting policies of speciality chemicals and materials group Laporte’s 1996 accounts shows (Extract 8.2).
As depreciation is somewhat subjective, it is possible that the market value of fixed assets could be different from the value shown in the accounts. The proposals in FRED 15 (Impair- ment of Fixed Assets and Goodwill) would ensure that they are not shown at a value that is higher than their market value. FRED 15 proposes that all fixed assets should be subject to an ‘impairment review’ when circumstances indicate that their value may have fallen. The proposed standard offers a wide range of situations when an impairment review would be appropriate, including rationalisation programmes, operating losses, cash outflows from DEPRECIATION
Fixed assets, less estimated residual values, are depreciated on a straight-line basis over their estimated useful lives, which are reviewed periodically. The criteria for future lives are:
● plant, plant-specific buildings and equipment – maximum of 15 years
● freehold buildings (excluding plant-specific buildings) – maximum 50 years
● leasehold properties – term of lease
● freehold land – not depreciated
DEPRECIATION (LAPORTE) Extract 8.2
operating activities, as well as the decline in the market value. Most losses would be charged to the profit and loss account in the year that the loss is recognised, impairment of fixed assets that have previously been revalued are shown in the statement of total recognised gains and losss to the extent of the previous revaluation. Any further impairment should be shown in the profit and loss account.
8 Depreciation of assets
In the UK companies can choose the method of depreciation, and the straight-line method is usually used. The reducing-balance method and the sum-of-the-digits method give higher charges in the earlier years than the straight-line method. This probably more closely reflects the reduction in the market value of the asset. Whereas usage-based meth- ods bring in depreciation charges that reflect the use of the asset, rather than its market value. The straight-line method is the simplest of all, and allocates the costs equally over the life of the asset. The annuity method is very rarely used.
The different methods of depreciation will give different depreciation charges, and these are illustrated in Figure 8.1.
FRED 15 proposes that any impairment in the value of assets should be charged to the appropriate financial statement in the year that the impairment is recognised. Most impairments would be shown in the profit and loss account. The only exception is assets that have previously been revalued, where the impairment will be shown on the state- ment of total recognised gains and losses to the extent of the previous revaluation. Fur- ther impairments should be charged to the profit and loss account in the normal way.
SUMMARY
FOUR DEPRECIATION METHODS AND THEIR DIFFERING CHARGES Figure 8.1
Annual depreciation charge Thousands
0 1 3 4 5
2
Straight line Reducing balance Year
Sum of the digits Production hours 6
1 2 3 4 5
INTERNATIONAL DIFFERENCES
Companies outside of the UK have less flexibility in calculating their depreciation charge, as depreciation is often linked to tax allowances.
International accounting standards
There are two international accounting standards covering depreciation; IAS 4 (Depreciation Accounting) and IAS 16 (Property, Plant and Equipment). Neither standard currently gives any guidance about the method that should be used for calculating depreciation.
Europe
The depreciation charge is linked to tax allowances in the accounts of individual companies in France and Germany, but in the consolidated accounts it is more common to show a true and fair view. In Germany asset lives and depreciation are commonly based on the tax tables, however there will be disclosures about this in the notes to the accounts. Since 1994, it has become common practice for large German groups to adopt options that comply with inter- national accounting standards but would not be tax efficient under the principle of Mass- geblichkeitsprinzip. In 1995 the Justice Ministry announced that it would tolerate the use of international accounting standards in listed group company accounts. In France individual companies’ accounts would follow the tax tables, but the numbers are usually corrected to reflect the true and fair view when consolidated. In the Netherlands accounting depreciation usually follows tax depreciation, although it can be different.
Japan
Depreciation in Japan follows the tax tables, with the reducing-balance method being the most popular, as it gives a higher charge (and, therefore, tax allowance) in the earlier years.
North America
In the USA the asset lives should be reviewed annually and the annuity method is not accept- able. If a company changes the method they must show an adjustment for the cumulative effect of the change in the income statement.
In Canada depreciation should be recognised in a systematic manner that is appropriate to the asset and its use.