Thursday, October 16, 2008

Using Depreciated Replacement Cost as a valuation approach of PPE Measurement

IAS 16 Property, Plant and Equipment provides for two acceptable alternative approaches to accounting for long-lived tangible assets.

Paragraph 29 of IAS 16 stated that an entity shall choose either the cost model in par. 30 or the revaluation model in par. 31 as its accounting policy and shall apply that policy to an entire class of property, plant and equipment.

Using the Cost model, after recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses (par. 30).

Using the Revaluation model, after recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated 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 (par. 31).

Further, par. 32 of IAS 16 stated that “The fair value of land and buildings is usually determined from market-based evidence by appraisal that is normally undertaken by professionally qualified valuers. The fair value of items of plant and equipment is usually their market value determined by appraisal.”

Furthermore, par. 33 stated that “If there is no-market-based evidence of fair value because of the specialized nature of the item of property, plant and equipment and the item is rarely sold, except as part of a continuing business, an entity may need to estimate fair value using an income or a depreciated replacement cost approach.”

Wiley – IFRS 2008, Interpretation and Application of IFRS explained that replacement cost deals with the service potential of the asset, which is after all what truly represents value for its owner.

An obvious example can be found in the realm of computers. While the cost to reproduce a particular mainframe machine exactly might be the same or somewhat lower today versus its original purchase price, the computing capacity of the machine might easily be replaced by one or a small group of microcomputers that could be obtained for a fraction of the cost of the larger machine.

Even replacement cost, if reported on a gross basis, would be an exaggeration of the value implicit in the reporting entity’s asset holdings, since the asset in question has already had some fraction of its service life expire. The concept of sound value addresses this concern.

Sound value is the equivalent of the cost of replacement of the service potential of the asset, adjusted to reflect the relative loss in its utility due to the passage of time or the fraction of total productive capacity that has already been utilized.

Example of depreciated replacement cost (sound value) as a valuation approach :

An asset acquired January 1, 2005 at a cost of € 40,000 was expected to have a useful economic life of 10 years. On January 1, 2008, it is appraised as having a gross replacement cost of € 50,000. The sound value, or depreciated replacement cost, would be 7/10 x € 50,000 or € 35,000. This compares with a book, or carrying value of € 28,000 at the same date. Mechanically, to accomplish a revaluation at January 1, 2008, the asset should be written up by € 10,000 (i.e from € 40,000 to € 50,000 gross cost) and the accumulated depreciation should be proportionally written up by € 3,000 (from € 12,000 to € 15,000). Under IAS 16, the net amount of the revaluation adjustment, € 7,000 would be recognized in other comprehensive income and accumulated in revaluation surplus, an additional equity account.

(Source : Wiley IFRS 2008 : Interpretation and Application of International Accounting and Financial Reporting Standards 2008)

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