INTERNATIONAL ACCOUNTING STANDARD (IAS) 16 PROPERTY, PLANT AND EQUIPMENT The objective of this Standard is to prescribe the accounting

treatment for property, plant and equipment so that users of the financial statements can discern information about an entitys investment in its property, plant and equipment and the changes in such investment. The principal issues in accounting for property, plant and equipment are the recognition of the assets, the determination of their carrying amounts and the depreciation charges and impairment losses to be recognised in relation to them. DEPRECIATION This is a term used to describe the expense that results from the loss of usefulness of an asset due to age, wear and tear, and obsolescence. This adjustment spreads the cost of an asset over its useful life. Depreciation therefore refers to two very different but related concepts: 1. the decrease in value of assets (fair value depreciation), and 2. The allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Depreciation is ALWAYS recorded by debiting an expense account named Depreciation Expense and crediting an account Contra Account (accumulated depreciation). The balance of this contra-asset account is a creditthe opposite of an asset account. The amount is not shown as a credit to the asset account, but in this separate contra-asset account. There will be an individual account for each item that is being depreciated e.g. office equipment, store equipment, automobile, delivery truck, etc. Land is never depreciated CALCULATING DEPRECIATION To calculate depreciation, three pieces of information are used: 1. Depreciation Base The depreciation base is usually the historical cost of the asset net of any positive adjustments and negative adjustments. Positive adjustments usually reflect improvements/additions. Negative adjustments may be partial dispositions, accumulated depreciation, and salvage value. 2. Useful Life The useful life of an asset is an estimate and represents the number of years the asset is expected to be in service. The depreciation base is allocated over the useful life. 3. Depreciation Method - Depreciation methods represent the mechanism for allocating the cost of the asset to each accounting period. Two methods are used when depreciating assets, namely; 1. Time-based depreciation methods 2. Activity-based depreciation methods TIME-BASED DEPRECIATION METHODS Time-based depreciation allocates the cost of the asset based on time. Each time1

based depreciation method requires an adopted convention. The convention determines how the asset will be depreciated in the year the asset is acquired. For instance, if the entity adopts a full-month convention, then depreciation will be calculated for the entire month in the month of acquisition. There are numerous conventions relating to months, quarters, and years - it is up to the reporting entity to determine which method to use. The following time-based depreciation methods are acceptable: 1. Straight-Line depreciation This method allocates an equal amount of the cost of an asset to each time period within the useful life of the asset. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation. The depreciation charge for the asset can be calculated using the following formula: Annual depreciation expense = 2. Reducing balance method The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages. To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance as below; Depreciation rate (r) n s c = 1 n

cost of fixed asset residual value Useful life of asset (years)

s/c x

100

Number of years Residual value Cost of the asset

For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation expense with the pattern of benefits. 3. Double-Declining-Balance method Double-declining-balance depreciation is an accelerated depreciation method. It allocates a greater percentage of the asset to early periods and a smaller percentage of the asset to later periods. The basic premise of this method is that as an asset ages, it begins to wear out, thus provides less value. Double-declining-balance depreciation is twice the rate of straight-line depreciation. For example, if an asset has a useful life of 5 years, the straight-line rate is 20% per year. Since double-declining-balance depreciation is twice the straight-line rate, the rate will be 40% per year. At a certain point in the asset's life, the double-declining-balance depreciation amount will be less than straight-line depreciation would be. 4. Sum-of-the-Years-Digits method Sum-of-the-years-digits depreciation is an accelerated depreciation method that allocates a greater percentage of the asset to early periods and a smaller percentage of the asset to later periods. The basic premise of this method is that as an asset ages, it begins to wear out, thus providing less value.

This method divides the number of time periods remaining by the sum of the total number of time periods. For example, the year one allocation rate of a five-year asset would be 5/15ths (33%) and the year two rate would be 4/15ths (27%) (The denominator is the sum of the years of the useful life.). ACTIVITY BASED DEPRECIATION METHODS These methods estimate the service life in terms of some measure of productivity. The argument behind the use of the methods is that its more logical to allocate an asset cost to periods of asset use is to measure the usefulness of the asset in terms its productivity. The most common activity based method is the units of production method. 1. Units-of-production depreciation method Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:

DEPLETION Allocation of cost of natural resources is referred to as depletion. Because the usefulness of natural resources generally is directly related to the amount of resources extracted, the activity based units of production method is widely used to calculate periodic depletion. Service life is therefore the estimated amount of natural resources to be extracted. Example one Jolly mining corporation paid sh 1,000,000 for the rights to explore for mineral deposits on 500 acres of land in Kitui. Costs for exploring for minerals deposits were sh 800,000and intangible development costs incurred in digging and erecting a mine shaft were sh 500,000. In addition, the corporation purchased new excavating equipment for sh 600,000. After the minerals are exhausted, the equipment will be sold for sh 60,000. The corporation geologist estimates that one million tons of minerals will be extracted over a three year period. During 2010, 300,000 tons were extracted Required 1. Determine the amount of depletion that should be charged 2. Show the relevant journal entries AMORTIZATION OF INTANGIBLE ASSETS amortization refers to expensing the acquisition cost minus the residual value of intangible assets (often intellectual property such as patents and trademarks or copyrights) in a systematic manner over their estimated useful economic lives so as to reflect their consumption, expiry, obsolescence or other decline in value as a result of use or the passage of time. 3

A corresponding concept for tangible assets is depreciation. Methodologies for allocating amortization to each accounting period are generally the same as for depreciation. However, many intangible assets such as goodwill or certain brands may be deemed to have an indefinite useful life and are therefore not subject to amortization. However goodwill is subjected to impairment test every year. Amortization is recorded in the financial statements of an entity as a reduction in the carrying value of the intangible asset in the balance sheet and as an expense in the income statement. Depreciation sample questions Example one X Company bought a fabricating machine on January 2008 at a net cost of sh 130,000. At the end of its four year useful life, the company estimates that the machine be worth sh 30,000. The company has estimated the machine will run for 25,000 hours during its four years useful life. The company fiscal year ends on December 31st Required Computed depreciation for 2008 through 1011 using the following methods; 1. 2. 3. 4. 5. straight line method reducing balance method sum-of-the-year digit method double declining method units of production method given that the actual production was as follows; Year machine hours 2008 6,000 2009 8,000 2010 5,000 2011 7,000

Example two Mercy holdings purchased a machine for sh 250,000. The company expects the useful life of the machine to be 5 years. During this time, its expected the machine will produce140, 000 units. The anticipated residual value sh 40,000 the machine was disposed after five years of use. Actual production during the five years of the asset life was as follows; Year 1 2 3 4 5 Required Computed depreciation using the following methods; units produced 24,000 36,000 46,000 8,000 16,000

1. 2. 3. 4. 5.

straight line method reducing balance method sum-of-the-year digit method double declining method units of production method