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Depreciation and IFRS Excepting rare instances where productive processes do not interact, and very high levels

of input aggregation, financial accountings allocation assertions are ambiguous and incorrigible. They may be employed to code the accountants communication of estimates about the firm (as in estimation theory), but allocation assertions do not reflect anything that exists in the external world, and do not correspond to any aspects of the firms economic state or activities. (Arthur Thomas) 1 Before leaving this subject, we should issue an important warning: Investors are often led astray by CEOs and Wall Street analysts who equate depreciation charges with the amortization charges [of goodwill] we have just discussed. In no way are the two the same: With rare exceptions, depreciation is an economic cost every bit as real as wages, materials, or taxes. Certainly that is true at Berkshire and at virtually all the other businesses we have studied. Furthermore, we do not think so-called EBITDA (earnings before interest, taxes, depreciation and amortization) is a meaningful measure of performance. Managements that dismiss the importance of depreciation - and emphasize "cash flow" or EBITDA - are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions. (Warren Buffett) 2

In recent years, standard-setters have paid little attention to fixed asset accounting and depreciation. The quotes from Arthur Thomas and Warren Buffett perhaps capture the dilemma. Depreciation is an inexact measure derived from a past transaction. It has none of the apparent science and precision found in estimates of fair value used for financial instruments. But as Buffett says, it is a real economic cost. For manufacturing and trading companies, fixed assets and depreciation are far more significant to measuring economic success or failure than financial instruments. As jurisdictions implement International Financial Reporting Standards (IFRSs), many find that the accounting for fixed assets is a special challenge. Their previous accounting was often influenced or governed by tax, rather than financial, reporting rules. They wonder how much their previous practices must change to conform to the guidance in IAS 16, Property, Plant and

Arthur L. Thomas, The Allocation Problem in Financial Accounting Theory, Studies in Accounting Research, no. 3, and The Allocation Problem: Part Two, Studies in Accounting Research, no. 9. (Evanston, Ill.: American Accounting Association, 1969 and 1974, respectively).

Buffett, Warren E., BERKSHIRE HATHAWAY INC. AN OWNER'S MANUAL, A Message from Warren E. Buffett, Chairman and CEO, January 1999.

This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS Equipment. This short article attempts to assist in answering those questions by examining some of the principles in IAS 16.

Component accounting is the first challenge in IAS 16. Many companies are accustomed to aggregating fixed assets into large units of accountperhaps accounting for a building, an aircraft, or an oil production facility as a single asset. Paragraph 9 of IAS 16 reads: This Standard does not prescribe the unit of measure for recognition, ie what constitutes an item of property, plant and equipment. Thus, judgement is required in applying the recognition criteria to an entitys specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. However, and this is more significant to fixed-asset record-keeping systems, paragraphs 43 and 44 read: Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately 3 . An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease. Some express concern that those paragraphs require an entity to subdivide its fixed assets into dozens of component parts. As with everything in IFRS, the key words are judgement is required. There is little point in allocating the cost of an asset to components if the effect of doing so is not material. Still, some assets have components with useful lives that are significantly different from one another, and some jurisdictions already separate assets into components. For example, a buildings, elevators, and heating/air conditioning plant may have lives that are shorter than that of the building shell. In a manufacturing facility, custom-built assembly lines may have lives that are shorter than that of the rest of the facility. IFRSs require allocation among those component parts for purposes of computing depreciation.

The use of bold italics in quotations from IFRSs reflects the usage in the original text.

This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS Paragraph BC 26 explains the Boards reasoning: The Boards discussions about the potential improvements to the depreciation principle in the previous version of IAS 16 included consideration of the unit of measure an entity uses to depreciate its items of property, plant and equipment. Of particular concern to the Board were situations in which the unit of measure is the item as a whole even though that item may be composed of significant parts with individually varying useful lives or consumption patterns. The Board did not believe that, in these situations, an entitys use of approximation techniques, such as a weighted average useful life for the item as a whole, resulted in depreciation that faithfully represents an entitys varying expectations for the significant parts.

Paragraph 6 of IAS 16 defines residual value as: The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. That definition can be restated as a simple question. If the asset was at the end of its useful life today, and was in the condition expected at the end of its useful life, what would the company receive today from selling the asset (net of disposal costs)? IAS 16 also requires that the residual value of assets must be reviewed annually. If an assets residual value is greater than its net carrying amount, then there is no charge for depreciation. Does this require management to make an annual detailed review of its fixed asset records? Probably not in many situations. Again, judgement is required. The residual value of some assets, such as aircraft, may change significantly from period to period. Other assets, such as those used in manufacturing facilities, may have residual values that do not change from period to period. Management should have a policy for identifying and monitoring changes in assets.

This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS Some jurisdictions have a tax policy of depreciating all assets to a nominal value of CU 1. IFRSs do not permit such a blanket policy. It may be appropriate for some assets, especially those that will be obsolete at the end of their useful lives 4 .

Paragraph 6 of IAS 16 defines useful life as: (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an entity. Jurisdictions have adopted a variety of, again tax-based, systems for estimating useful lives. Some are quite broad, for example specifying a life of seven years for all items other than real estate. Others are quite detailed. The question for those adopting IFRSs is not the level of detail provided by tax guidelines, but the degree to which the specified detail conforms to the economic expectations described in IAS 16. There is a subtle element in IAS 16s notion of useful life. Item (a) above refers to the period . . . available for use by an entity. 5 That period may differ from an assets total economic life. For example, consider a vehicle that has an economic life of 10 years. The entity has a practice of holding vehicles for 3 years and then replacing them with new vehicles. The useful life in this case is 3 years rather than 10 years. The residual value will be higher in this case than it would be if the entity intended to hold its vehicles for 10 years.

Paragraph 53 of IAS 16 notes that, In practice, the residual value of an asset is often insignificant and therefore immaterial in the calculation of the depreciable amount. 5 Paragraph 57 reads: The useful life of an asset is defined in terms of the assets expected utility to the entity. The asset management policy of the entity may involve the disposal of assets after a specified time or after consumption of a specified proportion of the future economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter than its economic life. The estimation of the useful life of the asset is a matter of judgement based on the experience of the entity with similar assets. This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS

Of all IAS 16s requirements, the selection of depreciation methods can have the largest effect on reported profit or loss. Yet the standard devotes only a few paragraphs to the topic. Paragraph 60 captures the principle: The depreciation method used shall reflect the pattern in which the assets future economic benefits are expected to be consumed by the entity. The requirement, then, is simple. IAS 16 requires a depreciation method that is consistent with the pattern of consumption of economic benefits, to the extent possible within the limits of any accounting allocation method. Selection of a method is not a free choice. The application is far from simple. In many cases there is no external evidence about the pattern in which economic benefits are consumed. Here we encounter Thomass admonition about accounting allocations (see the passage quoted on page 1). To some degree, all accountings allocation assertions are ambiguous and incorrigible. There is no single correct answer, and nor is a single method likely to be appropriate for all of an entitys fixed assets. Sometimes, the pattern of future benefits can be described in a clear way. For example, the use of a toll road (refer to IFRIC Interpretation 12, Service Concession Arrangements) may be low in early periods and high in later periods. In such a situation, a depreciation method based on the expected number of cars using the road (a units-of-production approach) may be appropriate. A simple straight-line convention would not reflect the pattern of future economic benefits from the asset. On the other hand, describing the consumption pattern of future economic benefits from a machine tool or computer is a much harder task. But what does the IASB mean by consumption of future economic benefits? Every asset on a companys statement of financial position represents a bundle of future economic benefits. Those benefits may be direct, as in the cash flows from a financial instrument, or indirect, as in the benefits derived from an item of office furniture. The objective of a depreciation method, then, is to approximate the pattern in which the bundle of economic benefits diminishes over time. Paragraph 56 offers the following guidance about useful life, but it may also be helpful in considering the pattern of consumption: This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economic benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset: (a) expected usage of the asset. Usage is assessed by reference to the assets expected capacity or physical output. (b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle. (c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset. (d) legal or similar limits on the use of the asset, such as the expiry dates of related leases. Is the list all-inclusive? Are those the only factors that an entitys management might consider when evaluating the pattern of consumption? I think not. (IAS 38, Intangible Assets, includes a longer list that also may be helpful in thinking about fixed assets.) For example, many assets require more repairs and more frequent maintenance in the later years of their lives. Similarly, management may expect that the price of a product produced by an asset will decline over the assets life. Both suggest that a declining balance method may be a better approximation of the pattern of consumption. Paragraph 52 of IAS 16 makes it clear that the consumption of economic benefits is not the same as changes in the fair value of an asset. Nor is depreciation a substitute for recognition of impairment, if an asset is impaired (refer to IAS 36, Impairment of Assets) or the recognition of liabilities that may be related to fixed assets (refer to IAS 37, Provisions). Is there a preference in IAS 16 for the straight-line method over other methods? Again, I think not. The straight-line method may be the easiest to administer and for financial statement users to understand, in the absence of evidence to the contrary. Those factors make it the easiest method, but not necessarily the preferred method.

This article represents the views of the author and is not an official pronouncement of the IASB.

Depreciation and IFRS Consider a manufacturing plant that has 250 items in the fixed asset register. Management has determined that a declining-balance method best represents the best estimate of consumption for the major items in the register. Can it apply the method to all the items in the plant and, thus, simplify the record-keeping? IAS 16 does not provide guidance at that level of detail. However, if the major parts of a manufacturing plant are consumed in a declining pattern, managers might reasonably assert that other items in that plant would follow the same pattern. Are there depreciation methods prohibited by IFRS? Yes. Although IAS 16 does not mention interest-based depreciation methods, the IASB and its interpretations committee have considered those methods on several occasions and have not incorporated them in the IFRSs and Interpretations. The selection of a depreciation method and the pattern of depreciation charges, is ,then, constrained by the requirements found in paragraphs 32 to 38 of IAS 8 Accounting Policies,

Changes in Accounting Estimates and Errors. The extent to which an entitys management
documents its choice of depreciation methods is a matter of internal control over the financial reporting process. IFRSs do not specify the detail with which that documentation should be prepared. Instead, judgements about depreciation and documentation are a matter left to the judgement of the entitys management and auditors.

Management will, no doubt, encounter other questions about fixed-asset accounting that are not covered in detail in IFRSs or in this article. For example, does IAS 16 permit a convention that switches from a declining-balance approach to straight-line at the midpoint in an assets life? (IAS 16 is silent on the point.) Should an entitys accounting for fixed assets be consistent across its various operations? (Yes, in the absence of evidence to the contrary.) In particular, this article does not address how an entity should manage changes in depreciation policy that accompany application of IFRS 1, First-time Adoption of International Financial Reporting Standards. As before, judgement is required. We hope that this short article helps management and auditors by providing a framework for the exercise of that judgement.

This article represents the views of the author and is not an official pronouncement of the IASB.