Contents of Part 2
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| 2.2 Accounting concepts |
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Recognition of assets
An asset should be recognised in the financial statements of an entity if it meets all of the following criteria:
Service potential
The concept of ‘service potential’ relates
to the fundamental nature of an asset –
it exists or is acquired to support a service. Typical ‘services’
may be the provision of filtered water, accommodation for administrative
workers, the clinical treatment of patients, or the processing
and transfer of information.
The term ‘potential’ is used because the asset itself does not provide the service – it only contributes to the delivery of the service. Also, the capacity of the asset to support the delivery of services may not be fully utilised. Service potential is a measure of the ability of the asset to fulfil its role in service delivery.
Decline in the service potential of an asset typically occurs over time through:
Financial recognition of the decline in service potential over the life of an asset is through the use of depreciation, which is discussed below. A decline in service potential can be arrested or reversed by enhancing or refurbishing the asset. When this occurs, the asset should be revalued.
Service potential is also referred to as ‘future economic benefit’.
Depreciation
Depreciation recognises the cost of consuming the
service potential of an asset over time, and provides a means
of accounting for the cost of an asset over its useful life.
The recognition of depreciation charges is necessary for the valuation of assets and costing of services, and is also used for resource allocation and asset performance assessment. Depreciation is not normally funded and does not provide cash for the replacement of an asset.
Depreciation can be calculated in several ways. Some methods are arithmetical, such as the straight-line or reducing balance techniques. Others are designed to reflect the actual condition or capacity of the asset as realised over time (such as the production unit method, or 'condition-based depreciation'). The method chosen should match the pattern of service potential yielded by the asset as closely as possible, and the depreciation charge will then be a realistic reflection of the cost of providing the services by using the asset.
Depreciation rates must be reviewed annually and, if necessary, adjusted to reflect the most recent assessments of the asset's useful life (see the section on useful life below for issues to be considered in making this assessment).
Useful life
An asset’s useful life is the period over which
it is expected to provide the entity with service. Depending on
the nature of the asset, useful life can be expressed in terms of time (years) or output (production or service units).
Useful life must be realistically assessed. Entities should consider the following:
Consideration of these factors will enable the expected life of an asset to be assessed realistically. Useful life is an important determinant of the rate of depreciation.
Valuation
Improved financial and asset information
is needed for the implementation of accrual accounting in the
public sector. The Victorian Financial Management Act 1994 requires that all assets controlled by the Victorian Government be recognised and valued.
Australian Accounting Standards provide the overall framework for all accounting in the budget sector. Australian Accounting Standard 29, Financial Reporting by Government Entities, is particularly applicable. The Accrual Accounting Manual, issued by the Department of Finance, provides further detailed guidance on the accounting treatment of asset valuation, depreciation and revaluation issues.
The Department of Finance publication, Recognition and Valuation of Non-current Physical Assets, establishes a framework for valuing such assets. The document also covers depreciation and revaluation.
The implementation of these measures is a core element of the Government's reform of financial management in Victoria.
Enhancement and refurbishment
Assets are often modified during their life. There
are two main types of modification:
Enhancement: where works are carried out on the asset that increase its service potential. Works of this kind may be extensions, or modifications to improve functionality such as installing computer cabling or increasing the speed of a lift. Enhancements normally increase the service potential of the asset, and result in an increase in value; and
Refurbishment: where major works are carried out to bring or restore the asset to acceptable condition. Refurbishment works do not necessarily extend functionality or the life of the asset, but are necessary for the planned life to be achieved. In such cases, the value of the asset is not affected.
If the refurbishment extends the useful life of an asset, the service potential (and value) of the asset is increased accordingly.
Types of asset expenditure
Expenditure on assets may be incurred using capital
or recurrent funds. The acquisition of new assets is a capital expense. In addition,
expenditure on an existing asset is treated as capital expenditure
if it:
Any expenditure on an existing asset that falls outside this definition is classified as an operating expense and met from recurrent funds. An example of this is maintenance expenditure. By comparison with capital expenditure, maintenance expenditure enables an asset to last its expected useful life but does not extend its service potential. (Expenditure on minor repairs and cyclical maintenance, such as on painting and cleaning guttering, are examples of maintenance expenditure.)
| The capital charge A capital charge applies to all entities in order to distribute part of the centrally funded annual cost of capital. This gives entities greater incentive to increase the performance of their asset base by encouraging maintenance, rather than inefficient replacement; redeployment rather than retention; and completion of construction and acquisition on time and according to specification. 2 |
The capital charge on funds reflects the cost of these funds, which are derived from a mix of external borrowings at commercial rates and funds generated from taxes. The capital charge is the means used to measure the cost of capital that entities have invested in the assets under their control.
The essential features of the capital charge are as follows:
The capital charge must be taken into account when calculating the full cost of an asset for pricing purposes. It will form part of the core cost that should be recovered (except in special circumstances where assets are provided at minimal or no cost - see Section 8).
| Budget Information Paper No. 2 – Budget Performance and Outlook Victorian Government, 1994
Department of Treasury and Finance, |
2 Budget Information Paper No. 1
Public Sector Capital Works, 1994-95
Victorian Governement
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