ABC airline owns five air crafts which it uses in its business as property, plant, and equipment. You are required to comment whether it is possible for ABC to carry two crafts under the cost model and the remaining three crafts under the revaluation model?
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Your answer must be confined in two to three lines.
Under IFRS, there is a choice to be made in accounting policy either at cost and depreciating, or accounting at fair value using Revaluation Model and depreciating. This choice is available on a class by class basis.
Example – suppose that a company has Land and Building that is used for a corporate head office and it is easier to re-measure at FV. This can be done, but IFRS rules require that all buildings used in the same manner in the entities operations must be also be accounted for at FV.
In the Revaluation model, any increase in FV does not go through the Income Statement. Instead, it is recognized directly in Balance Sheet Equity – Revaluation Surplus. Only if there is a decrease in FV, over and above any previous increases, does it go through the Income Statement as an expense item. Therefore, any revaluations that go below the original cost (what was originally paid) must go to the Income statement. Any revaluations that increase FV are recognized directly in Equity (Statement of Changes in Equity). Revaluations that decrease FV but remain above original cost are also recognized in Equity. The basic premise is that revaluations do not affect the Income Statement, but rather are recognized in Equity, unless the revaluation decreases an asset value below its original cost – in this situation it would affect the Income Statement as an expense item.
First, please understand that there is a difference in IFRS between the Fair Value Model and Revaluation Model. The REVALUATION model pertains to Property Plant & Equipment under IAS 16, whereas the FAIR VALUE Model pertains to INVESTMENT PROPERTY, under IAS 40 and is discussed in a separate blog.
Under IFRS, there is a choice to be made in accounting policy - either at COST and depreciating, which is essentially the same as Canadian GAAP, or FAIR VALUE using REVALUATION Model and depreciating.
This choice is available on a class by class basis, and a company can choose whatever is most convenient and relevant for them to use.
However, once the choice is made, it should be followed on a consistent basis. Later in this blog I will also discuss the elections available under IFRS-1, which may be helpful during the initial transition to IFRS.
The key fair value measurement concepts of the Revaluation Model are:
• It should be Market based.
• Determined by professionally qualified valuators and
• The frequency of revaluation depends to the type of asset and its price volatility.
Here are a few extracts from the IAS standards to give you a sense of the detail involved….
31 An item of property, plant and equipment whose fair value can be measured reliably shall be carried at its fair value at the date of the revaluation, less any subsequent accumulated depreciation and impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.
32 The fair value of land and buildings is usually determined from market-based evidence by appraisal that is normally undertaken by professionally qualified valuators. The fair value of items of plant and equipment is usually their market value determined by appraisal.
36 If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued.
The key concept is that, for the most part, any revaluations will impact EQUITY, and not Operating income.
In the Revaluation model, any increase in Fair Value does not go through OPERATING INCOME.
Instead, it is recognized directly on the Balance Sheet.
On the asset side – the carrying amount of PP&E is increased.
On the liability side, the increase goes directly to Equity – Revaluation Surplus.
A decrease in Fair Value also affects the Balance Sheet only – in other words no impact to Operating income.
Only if there is a decrease in Fair Value, below any previous increases, does it go through Operating Income as an expense item.
So, in summary…
• Revaluations that increase FV are recognized directly in Equity.
• Revaluations that decrease FV but remain above original Carrying value are also recognized in Equity.
• Revaluations that go below the original Carrying value go to the Income Statement.
To help with the understanding, I thought it would be helpful to provide an example. Suppose that a company has Land and Building that is used for a corporate head office, and they decide to use the Revaluation Model, and to re-measure at Fair Value. IFRS rules require that all buildings used in the same manner in the entities operations, must be also be accounted for at Fair Value using the Revaluation Model.
Just to make sure everyone understands what I mean by an asset class…..a class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. The following are examples of separate classes:
(b) Land and buildings;
(f) Motor vehicles;
(g) Furniture and fixtures; and
(h) Office equipment.
These asset groups are similar to what we all are familiar with under Canadian GAAP.
In this example Land and Building have a Carrying Value of $100, and has a fair value of $120.
With the Revaluation model, the $20 increase in Fair Value is reported on the Balance Sheet as Equity - Revaluation Surplus.
At a later date, the Land and Building is revalued, and the Fair Value decreases to $110.
In this situation, the carrying value of the asset decreases by $10, and the change is reported as a decrease in Equity.
Finally, the Land and Building are revalued again, and the Fair Value decreases to $90.
In this situation, the carrying value of the asset decreases by $20.
Of this change, $10 is reported as a decrease in Equity.
A further $10 change is reported as an expense, and would flow through Operating Income.
Once again, the basic premise is that revaluations do not affect the Operating Income, but rather are recognized directly in Equity, unless the revaluation decreases an asset value below its original carrying value – in this situation it would affect Operating Income as an expense item.
Note - in the presentation, I included a column for Comprehensive Income which is not Operating Income. I assume everyone is familiar with the difference. If not – very simply it can be thought of as a way to reconcile items that impact Balance Sheet Equity, but that do not impact Operating Income. The concept has been used in Canada since 2006, and will continue to exist with IFRS.
IAS 16 provides for two acceptable alternative approaches to accounting for long-lived tangible assets. The first of these is the historical cost method, under which acquisition or construction cost is used for initial recognition, subject to depreciation over the expected economic life and to possible write-down in the event of a permanent impairment in value. In many jurisdictions this is the only method allowed by statue, but a number of jurisdictions, particularly those with significant rates of inflation, do permit either full or selective revaluation and IAS 16 acknowledges this by also mandating what it calls the “revaluation model.”
The logic of recognizing revaluations relates to both the statement of financial position and the measure of periodic performance provided by the statement of comprehensive income. Due to the effects of inflation (which even if quite moderate when measured on an annual basis can compound dramatically during the lengthy period over which property, plant, and equipment remain in use) the statement of financial position can become a virtually meaningless agglomeration of dissimilar costs.
Furthermore, if the depreciation charge against profit is determined by reference to historical costs of assets required in much earlier periods, profits will be overstated, and will not reflect the cost of maintaining the entity’s asset base. Under these circumstances, a nominally profitable entity might find that is has self-liquidated and is unable to continue in existence, at least not with the same level of productive capacity, without new debt or equity infusions.
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