Sunday, October 19, 2008

The Revaluation Model of PPE Measurement (after Recognition)

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.

IAS 29, Financial Reporting in Hyperinflationary Economies, addresses adjustments to depreciation under conditions of hyperinflation. Use of the revaluation method is typically encountered in economies that from time to time suffer less significant inflation than that which necessitates application of the procedures specified by IAS 29.

As the basis for the revaluation method, the standard stipulates that it is fair value (defined as the amount for which the asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction) that is to be used in any such revaluations.

Furthermore, the standard requires that, once an entity undertakes revaluations, they must continue to be made with sufficient regularity that the carrying amounts in any subsequent statement of financial position are not materially at variance with then-current fair values.

In other words, if the reporting entity adopts the revaluation model, it cannot report statements of financial position that contain obsolete fair values, since that would not only obviate the purpose of the allowed treatment, but would actually make it impossible for the user to meaningfully interpret the financial statements.

IAS 16 suggests that fair value is usually determined by appraisers, using market-based evidence. Market values can also be used for machinery and equipment, but since such items often do not have readily determinable market values, particularly if intended for specialized applications, they may instead be valued at depreciated replacement cost.

IAS 16 also requires that if any assets are revalued, all other assets in those groupings or categories must also be revalued. This is necessary to prevent the presentation of a statement of financial position that contains an unintelligible and possibly misleading mix of historical costs and current values, and to preclude selective revaluation designed to maximize reported net assets.

Although IAS 16 requires revaluation of all assets in a given class, the standard recognizes that it may be more practical to accomplish this on a rolling, or cycle, basis. This could be done by revaluing one-third of the assets in a given asset category, such as machinery, in each year, so that as of any statement of financial position date one-third of the group is valued at current fair value, another one-third is valued at amounts that are one year obsolete, and another one-third are valued at amounts that are two years obsolete.

Unless values are changing rapidly, it is likely that the statement of financial position would not be materially distorted, and therefore, this approach would in all likelihood be a reasonable means to facilitate the revaluation process.

Source of this article : Wiley IFRS 2008 – Interpretation and Application of IFRS

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