Financial Reporting and Accounting Newsletter - January 2015

By Kylee Byrne - January 29, 2015

What are Acceptable Methods of Depreciation and Amortisation?

In this month’s newsletter, we consider the following two related issues:

  • which methods of depreciation of property, plant and equipment are acceptable; and
  • which methods of amortisation of intangible assets are acceptable. 

The AASB has recently amended AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets to:

  • establish the principle for the basis of depreciation and amortisation as being the expected pattern of consumption of the future economic benefits of an asset;
  • clarify that the use of revenue-based methods to calculate the depreciation of an item of property, plant and equipment is not appropriate; and
  • clarify that revenue is generally presumed to be an inappropriate basis for measuring the consumption of the economic benefits embodied in an intangible asset. This presumption, however, can be rebutted in certain limited circumstances.

1.    What is Depreciation and Amortisation?

Depreciation is the systematic allocation of the depreciable amount of an asset (property, plant and equipment) over its useful life. 

Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life. 

In both formulas, depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.

In both formulas, useful life is defined as:
•    the period over which an asset is expected to be available for use by an entity; or
•    the number of production or similar units expected to be obtained from the asset by an entity.

2.    Deprecation

2.1    What is the useful life of an item of property, plant and equipment?

The useful life of an item of property, plant and equipment is defined in terms of the asset’s 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. 

AASB 116 paragraph 56 has been amended to establish the principle for the basis of depreciation as being the expected pattern of consumption of the future economic benefits of an asset. AASB 116 paragraph 56 now states that 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. 

AASB 116 requires that, 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 asset’s 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; and
(d)    legal or similar limits on the use of the asset, such as the expiry dates of related leases.

It should be noted that expected future reductions in the selling price of an item that was produced using an asset could indicate the expectation of technical or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.

2.2    What is an acceptable depreciation method for an item of property, plant and equipment?

The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

A variety of depreciation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include:

  • the straight-line method. The diminishing balance method results in a decreasing charge over the useful life;
  • the diminishing balance method. The diminishing balance method results in a decreasing charge over the useful life; and
  • the units of production method. The units of production method results in a charge based on the expected use or output. 

The entity selects the method that most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. 

A depreciation method that is based on revenue that is generated by an activity that includes the use of an asset is not appropriate. The revenue generated by an activity that includes the use of an asset generally reflects factors other than the consumption of the economic benefits of the asset. For example, revenue is affected by other inputs and processes, selling activities and changes in sales volumes and prices. The price component of revenue may be affected by inflation, which has no bearing upon the way in which an asset is consumed.

3.    Amortisation

3.1    What is the useful life of an intangible asset?

An entity shall assess whether the useful life of an intangible asset is finite or indefinite and, if finite, the length of, or number of production or similar units constituting, that useful life. An intangible asset shall be regarded by the entity as having an indefinite useful life when, based on an analysis of all of the relevant factors, there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. The term ‘indefinite’ does not mean ‘infinite’. 

The accounting for an intangible asset is based on its useful life. An intangible asset with a finite useful life is amortised, and an intangible asset with an indefinite useful life is not.

AASB 138 paragraph 90 lists the following factors that are considered in determining the useful life of an intangible asset:

  • the expected usage of the asset by the entity and whether the asset could be managed efficiently by another management team; 
  • typical product life cycles for the asset and public information on estimates of useful lives of similar assets that are used in a similar way; 
  • technical, technological, commercial or other types of obsolescence; 
  • the stability of the industry in which the asset operates and changes in the market demand for the products or services output from the asset; 
  • expected actions by competitors or potential competitors; 
  • the level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the entity’s ability and intention to reach such a level; 
  • the period of control over the asset and legal or similar limits on the use of the asset, such as the expiry dates of related leases; and 
  • whether the useful life of the asset is dependent on the useful life of other assets of the entity. 

Given the history of rapid changes in technology, computer software and many other intangible assets are susceptible to technological obsolescence. Therefore, it is likely will often be the case that their useful life is short. Expected future reductions in the selling price of an item that was produced using an intangible asset could indicate the expectation of technological or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.

3.2    What is an acceptable amortisation period and amortisation method for an intangible asset?

The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used. 

A variety of amortisation methods, similar to depreciation methods, can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include: 

  • the straight-line method; 
  • the diminishing balance method; and 
  • the units of production method. 

The method used is selected on the basis of the expected pattern of consumption of the expected future economic benefits embodied in the asset and is applied consistently from period to period, unless there is a change in the expected pattern of consumption of those future economic benefits.

There is a rebuttable presumption that an amortisation method that is based on the revenue generated by an activity that includes the use of an intangible asset is inappropriate. The revenue generated by an activity that includes the use of an intangible asset typically reflects factors that are not directly linked to the consumption of the economic benefits embodied in the intangible asset. For example, revenue is affected by other inputs and processes, selling activities and changes in sales volumes and prices. The price component of revenue may be affected by inflation, which has no bearing upon the way in which an asset is consumed. This presumption can be overcome only in one of the following circumstances: 

  • the intangible asset is expressed as a measure of revenue; or
  • it can be demonstrated that revenue and the consumption of the economic benefits of the intangible asset are highly correlated. 

In choosing an appropriate amortisation method, an entity could determine the predominant limiting factor that is inherent in the intangible asset. For example, the contract that sets out the entity’s rights over its use of an intangible asset might specify the entity’s use of the intangible asset as:

  • a predetermined number of years (that is, time);
  • a number of units produced; or 
  • a fixed total amount of revenue to be generated. 

Identification of such a predominant limiting factor could serve as the starting point for the identification of the appropriate basis of amortisation, but another basis may be applied if it more closely reflects the expected pattern of consumption of economic benefits.

In the circumstance in which the predominant limiting factor that is inherent in an intangible asset is the achievement of a revenue threshold, the revenue to be generated can be an appropriate basis for amortisation. In the case in which revenue has been established as the predominant limiting factor in the contract for the use of the intangible asset, the revenue that is to be generated might be an appropriate basis for amortising the intangible asset, provided that the contract specifies a fixed total amount of revenue to be generated on which amortisation is to be determined.

Example 1

An entity acquires a concession to explore and extract gold from a gold mine. The expiry of the contract is based on a fixed amount of total revenue to be generated from the extraction. The contract allows for the extraction of gold from the mine until total cumulative revenue from the sale of gold reaches $2 billion and is not based on time or on the amount of gold extracted.

In this situation, the gold mine can be amortised using an amortisation method based on revenue generated.

Example 2

The right to operate a toll road is based on a fixed total amount of revenue to be generated from cumulative tolls charged. The contract allows operation of the toll road until the cumulative amount of tolls generated from operating the road reaches $100 million.

In this situation, the toll road can be amortised using an amortisation method based on revenue generated.

4.    Application Date

This Standard applies to annual reporting periods beginning on or after 1 January 2016. An entity shall apply those amendments prospectively. Earlier application is permitted. If an entity applies those amendments for an earlier period it shall disclose that fact.


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