Why Paragraph 17(e) of IAS 16 was Revised ?

In May 2020, the International Accounting Standards Board (IASB) issued the standard of Property, Plant and Equipment - Proceeds before Intended Use, as the amendments to IAS 16 Property, Plant and Equipment,. The amendments prohibit a company from deducting from the cost of property, plant and equipment amounts received from selling items produced while the company is preparing the assets for its intended use. Instead, a company will recognize such sales proceeds and related cost in profit or loss.

As described in the section of "Amendments to the Basis for Conclusions on IAS 16 Property, Plant and Equipment" of  May 2020 Amendments to IAS 16, before the 2020 amendment, paragraph 17(e) of IAS 16 specified that directly attributable costs included the costs of testing whether an asset was functioning properly, after deducting the net proceeds from selling items produced while bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. The Board received a request asking whether :

1. the proceeds specified in paragraph 17(e) related only to items produced while testing; and
2. an entity was required to deduct from the cost of an item of property, plant and equipment any such proceeds that exceeded the costs of testing

As explained in paragraph BC16B, the Board's research indicated that different entities had applied the requirements in paragraph 17(e) differently. Some entities deducted only proceeds from selling items produced while testing; others deducted the proceeds of all sales until an asset was in the location and condition necessary for it to be capable of operating in the manner intended by management (ie available for use). For some entities, the proceeds deducted from the cost of an item of property, plant and equipment could be significant and could exceed the costs of testing.

After considering the findings in paragraph BC16B, the Board decided to amend paragraph 17 to prohibit an entity from deducting from the cost of an item of property, plant and equipment the proceeds from selling items produced before that asset is available for use (proceeds before intended use). 

The Amendments to IAS 16 :  Property, Plant and Equipment - Proceeds before Intended Use, which was issued in May 2020 shall be applied by entity for annual reporting periods beginning on or after 1 January 2022. Earlier application is permitted. If an entity applies the amendments for an earlier period, it shall disclose that fact (HRD) ***

The Minimum Indications have to be considered in assessing IMPAIRMENT of Non Financial Assets

IAS 36 regulates the impairment of Non Financial Assets.

An asset is impaired when its carrying amount exceeds its recoverable amount. Paragraphs 12-14 of IAS 36 describe some indications that an impairment loss may have occurred. If any of those indications is present, an entity is required to make a FORMAL ESTIMATE OF RECOVERABLE AMOUNT. Except as described in paragraph 10, IAS 36 does not require an entity to make a formal estimate of recoverable amount if no indication of an impairment loss is present.

Paragraph 9 states that an entity shall assess at the end of each reporting period whether there is any indication  that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.

As stated in paragraph 12, in assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications :

EXTERNAL SOURCES OF INFORMATION

1. during the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use;
2. significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated;
3. market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially;
4. the carrying amount of the net assets of the entity is more than its market capitalisation

INTERNAL SOURCES OF INFORMATION

1. evidence is available of obsolescence or physical damage of an asset;
2. significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite;
3. evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected

DIVIDEND FROM A SUBSIDIARY, JOINTLY CONTROLLED ENTITY OR ASSOCIATE

1. for an investment in a subsidiary, jointly controlled entity or associate, the investor recognises a dividend from the investment and evidence is available that :

• the carrying amount of the investment in the separate financial statements exceeds the carrying amounts in the consolidated financial statements of the investee’s net assets, including associated goodwill; or
• the dividend exceeds the total comprehensive income of the subsidiary, jointly controlled entity or associate in the period the dividend is declared.

Further, paragraph 13 states that the list in paragraph 12 is not exhaustive. An entity may identify other indications that an asset may be impaired and these would also require the entity to determine the asset’s recoverable amount or, in the case of goodwill, perform an impairment test in accordance with paragraph 80-99 of IAS 36.

Evidence from internal reporting that indicates that an asset may be impaired, as stated within paragraph 14, includes the existence of :

1. cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted;
2. actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted;
3. a significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or
4. operating losses or net cash outflows for the asset, when current period amounts are aggregated with budgeted amounts for the future

As indicated in paragraph 10, IAS 36 requires an intangible asset with an indefinite useful life or not yet available for use and goodwill to be tested for impairment, at least annually (HRD).

Methods of adjusting ACCUMULATED DEPRECIATION at the date of REVALUATION

When an item of Property, Plant and Equipment is REVALUED, any accumulated depreciation at the date of the revaluation is treated in one of the following ways : (1) Restate accumulated depreciation proportionately with the change in the gross carrying amount of the asset (so that the carrying amount of the asset after revaluation equals its revalued amount); or (2) Eliminate the accumulated depreciation against the gross carrying amount of the asset (IAS 16 par. 35).

Example, Konin Corporation (KC) own buildings with a cost of USD200,000 and estimated useful life of five years. Accordingly, depreciation of USD40,000 per year is anticipated. After two years, KC obtains market information suggesting that a current fair value of the buildings is USD 300,000 and decided to write the building up to a fair value of USD300,000. There are two approaches to apply the revaluation model in IAS 38; the asset and accumulated depreciation can be “grossed up” to reflect the new fair value information, or the asset can be restated on a “net” basis. These two approaches are illustrated below. For both illustrations, the net carrying amount (book value or depreciated cost) immediately prior to the revaluation is USD120,000 (USD 200,000 - (2XUSD40,000)). The net upward revaluation is given by the difference between the fair value and net carrying value, or USD300,000 – USD120,000 = USD180,000.

Option 1. Applying the “gross up” approach, since the fair value after two years of the five-year useful life have already elapsed is found to be USD300,000, the gross fair value (gross carrying amount) must be 5/3 X USD300,000 = USD500,000. In order to have the net carrying value equal to the fair value after two years, the balance in accumulated depreciation needs to be USD200,000. Consequently, the buildings and accumulated depreciation accounts need to be restated upward as follows : buildings up USD300,000 (USD500,000 – USD200,000) and accumulated depreciation USD120,000 (USD200,000 – USD80,000). Alternatively, this revaluation could be accomplished by restating the buildings account and the accumulated depreciation account so that the ratio of net carrying amount to gross carrying amount is 60% (USD120,000/USD200.000) and the net carrying amount is USD300,000. New gross carrying amount is calculated USD300,000/60%=USD500,000.

The following journal entry illustrate the restatement of the accounts :

Buildings	300,000
Accumulated Depreciation		120,000
Other comprehensive income – gain on revaluation		180,000

And the following table illustrate the restatement of the accounts :

	Original cost		Revaluation		Total	%
Gross carrying amount	USD200,000	+	USD300,000	=	USD500,000	100
Accumulated Depreciation	80,000	+	120,000	=	200,000	40
Net carrying amount	USD120,000	+	USD180,000	=	USD300,000	60

After the revaluation, the carrying value of the building is USD300,000 (=USD500,000 – 200,000) and the ratio of net carrying amount to gross carrying amount is 60% (=USD300,000/USD500,000).

This method is often used when an asset is revalued by means of applying an index to determine its depreciated replacement cost.

Option 2. Applying the “netting” approach, KC would eliminate accumulated depreciation of USD80,000 and then increase the building account by USD180,000 so the net carrying amount is USD300,000 (=USD200,000 – USD80,000 + USD180,000). The journal entry as follow :

Acc. Depreciation	80,000
Buildings		80,000
Buildings	180,000
Other comprehensive income – gain on revaluation		180,000

This method is often used for buildings. In terms of total assets reported in the statement of financial position, option 2 has exactly the same effect as option 1.

However, many users of financial statements, including credit grantors and prospective investors, pay heed to the ratio of net property and equipment as a fraction of the related gross amounts. This is done to assess the relative age of the entity’s productive assets and, indirectly, to estimate the timing and amounts of cash needed for asset replacements. There is a significant diminution of information under the second method. Accordingly, the first approach described above, preserving the relationship between gross and net asset amounts after the revaluation, is recommended as the preferable alternative is the goal is meaningful financial reporting.

Source : WILEY – 2010 Interpretation and Application of IFRS, Barry J. Epstein and Eva K. Jermakowicz

Asset Exchange Transactions

Businesses sometimes engage in nonmonetary exchange transactions, where tangible or intangible assets are exchanged for other assets, without a cash transaction or with only a small amount of cash “settle up”. These exchanges can involve productive assets such as machinery and equipment, which are not held for sale under normal circumstances, or inventory items, which are intended for sale to customers.

IAS 16 Property, Plant and Equipment (PPE) provides authoritative guidance to the accounting for nonmonetary exchanges of tangible assets. It states that “an entity is required to measure an item of property, plant and equipment acquired in exchange for a non-monetary asset or assets, or a combination of monetary and non-monetary assets, at fair value unless the exchange transaction lacks commercial substance”.

The concept of  a purely “book value” exchange, as formerly employed in previous version of IAS 16, is now prohibited under most circumstances.

Paragraph 22 of the previous version of IAS 16 indicated that if (a) an item of PPE is acquired in exchange for a similar asset that has a similar use in the same line of business and has a similar fair value or (b) an item of PPE is sold in exchange for an equity interest in a similar asset, then no gain or loss is recognized on the transaction. The cost of the new asset is the carrying amount of the asset given up (rather than the fair value of the purchase consideration given for the new asset).

This requirement in the previous version of IAS 16 was consistent with views that :

1. gains should not be recognized on exchange of assets unless the exchanges represent the culmination of an earning process;
2. exchanges of assets of a similar nature and value are not a substantive event warranting the recognition of gains; and
3. requiring or permitting the recognition of gains from such exchanges enables entities to ‘manufacture’ gains by attributing inflated values to the assets exchanged, if the assets do not have observable market price in active markets.

Commercial Substance

Commercial substance is a new notion under IFRS, and is defined as the event or transaction causing the cash flows of the entity to change. That is, if the expected cash flows after the exchange differ from what would have been expected without this occurring, the exchange has commercial substance and is to be accounted for at fair value. In assessing whether this has occurred, the entity has to consider if the amount, timing and uncertainty of the cash flows from the new asset are different from the one given up, or if the entity-specific portion of the company’s operations will be different. If either of these is significant, then the transaction has commercial substance.

If the transaction does not have commercial substance, or the fair value of neither the asset received nor the asset given up can be measured reliably, then the asset acquired is valued a the carrying amount of the asset given up. Such situations are expected to be rare (Hrd).

(Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz and IAS 16 Property, Plant and Equipment)

How IAS 16 regulates the Depreciation of PPE ?

IAS 16 Property, Plant and Equipment Par. 43 states that each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately, and such depreciation charge shall be charged to the income statement unless it is included in the cost of producing another asset.

Depreciation shall be applied to the depreciable amount of an asset on a systematic basis over its expected useful life.

Expected useful life is the period used, not the asset’s economic life, which could be appreciably longer (IAS 16 Par. 57 states that the useful life of an asset 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 that 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).

The depreciable amount takes account of the expected residual value of the assets. Both the useful life and the residual value shall be reviewed annually and the estimates revised as necessary in accordance with IAS 8.

Depreciation still needs to be charged even if the fair value of an asset exceeds its residual value. The rationale for this is the definition of residual value, detailed above.

Residual value is the estimated amount, less estimated disposal costs, that could be currently realized from the asset’s disposal if the asset were already of an age and condition expected at the end of its useful life. This definition precludes the effect of inflation and, in all likelihood, will be less than fair value.

Depreciation commences when an assets is in the location and condition that enables it to be used in the manner intended by management. Depreciation shall cease at the earlier of its derecognition (sale or scrapping) or its reclassification as “held for sale”. Temporary idle activity does not preclude depreciating the asset, as future economic benefits are consumed not only through usage but also through wear and tear and obsolescence.

Useful life, therefore needs to be carefully determined based on use, maintenance programs, expected capacity, expected output, expected wear and tear, technical or commercial innovations, and legal limits.

(Source : IFRS Practical Implementation Guide and Workbook 2^nd Edition)

How to treat the costs incurred subsequent to purchase or self-construction of PPE

IAS 16 par. 7 states that the cost of an item of Property, Plant and Equipment (PPE) shall be recognized as an asset if, and only if :

1. it is probable that future economic benefits associated with the item will flow to the entity; and
2. the cost of the item can be measured reliably.

Further, par. 12 states that under the recognition principle in par. 7, an entity does not recognize in the carrying amount of an item of PPE the costs of the day-to-day servicing of the item. Rather, these costs are recognized in profit or loss as incurred. Costs of day-to-day servicing are primarily the costs of labor and consumables, and may include the cost of small parts. The purpose of these expenditures is often described as for the 'repairs and maintenance' of the item of PPE.

Costs that are incurred subsequent to the purchase or construction of the long-lived asset, such as those for repairs, maintenance, or betterments, may involve an adjustment to the carrying value, or may be expensed, depending on the precise facts and circumstances.

To qualify for capitalization, costs must be associated with incremental benefits. Costs can be added to the carrying value of the related asset only when it is probable that future economic benefits beyond those originally anticipated for the asset will be received by the entity. For example, modifications to the asset made to extend its useful life or to increase its capacity would be capitalized.

It can usually be assumed that ordinary maintenance and repair expenditures will occur on a ratable basis over the life of the asset and should be charged to expense as incurred. Thus, if the purpose of the expenditure is either to maintain the productive capacity anticipated when the asset was acquired or constructed, or to restore it to that level, the costs are not subject to capitalization.

A partial exception is encountered if an asset is acquired in a condition that necessitates that certain expenditures be incurred in order to put it into the appropriate state for its intended use. For example, a deteriorated building may be purchased with the intention that it be restored and then utilized as a factory or office facility. In such cases, costs that otherwise would be categorized as ordinary maintenance items might be subject to capitalization, subject to the constraint that the asset not be presented at a value that exceeds its recoverable amount. Once the restoration is completed, further expenditures of similar type would be viewed as being ordinary repairs or maintenance, and thus expensed as incurred.

However, costs associated with required inspections (e.g., of aircraft) could be capitalized and depreciated. These costs would be amortized over the expected period of benefit (i.e., the estimated time to the next inspection). As with the cost of physical assets, removal of any un-depreciated costs of previous inspections would be required. The capitalized inspection cost would have to be treated as a separate component of the asset. (Hrd)

Initial recognition of self-constructed assets

Essentially the same principles that have been established for recognition of the cost of purchased assets also apply to self-constructed assets. All costs that must be incurred to complete the construction of the asset can be added to the amount to be recognized initially, subject only to the constraint that if these costs exceed the recoverable amount, the excess must be expensed currently. This rule is necessary to avoid the "gold-plated hammer syndrome," whereby a misguided or unfortunate asset construction project incurs excessive costs that then find their way into the statement of financial position, consequently overstating the entity's current net worth and distorting future periods' earnings. Of course, internal (intra-company) profits cannot be allocated to construction costs. The standard specifies that "abnormal amounts" of wasted material, labor or other resources may not be added to the cost of the asset.

Self-constructed assets should include the cost of borrowed funds used during the period of construction (as set forth by IAS 23 regarding on capitalization of borrowing costs).

The other issue that arises most commonly in connection with self-constructed fixed assets relates to overhead allocations.

While capitalization of all direct costs (labor, materials, and variable overhead) is clearly required and proper, a controversy exists regarding the treatment of fixed overhead. Two alternative views of how to treat fixed overhead are to either :

1. Charge the asset with its fair, pro rata share of fixed overhead (i.e., use the same basis of allocation used for inventory); or

2. Charge the fixed asset account with only the identifiable incremental amount of fixed overhead.

While international standards do not address this concern, it may be instructive to consider the non-binding guidance to be found in US GAAP. AICPA Accounting Research Monograph 1 has suggested that :

----- in the absence of compelling evidence to the contrary, overhead costs considered to have "discernible future benefits" for the purposes of determining the cost of inventory should be presumed to have "discernible future benefits" for the purpose of determining the cost of a self-constructed depreciable asset.

The implication of this statement is that a logical similar to what was applied to determining which acquisition costs may be included in inventory might reasonably also be applied to the costing of PPE. Also, consistent with the standards applicable to inventories, if the costs of PPE items exceed realizable values, any excess costs should be written off to expense and not deferred to future periods.

(Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz)

The Scope of IAS 16 Property, Plant and Equipment

IAS 16 par. 2 to par. 5 described the scope of IAS 16 Property, Plant and Equipment (PPE)

This Standard shall be applied in accounting for property, plant and equipment except when another Standard requires or permits a different accounting treatment (par. 2).

Par. 3 states that this standard does not apply to :

(a)  property, plant and equipment classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations;

(b)  biological assets related to agricultural activity (see IAS 41 Agriculture);

(c)  the recognition and measurement of exploration and evaluation assets (see IFRS 6 Exploration for and Evaluation of Mineral Resources); or

(d)  mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources.

However, this Standard applies to PPE used to develop or maintain the assets described in (b)-(d).

Other Standards may require recognition of an item of PPE based on an approach different from that in this Standard. For example, IAS 17 Leases requires an entity to evaluate its recognition of an item of leased PPE on the basis of the transfer risks and rewards. However, in such cases other aspects of the accounting treatment for these assets, including depreciation, are prescribed by this Standard (par. 4).

Further, par. 5 states that an entity shall apply this Standard to property that is being constructed or developed for future use as investment property but does not yet satisfy the definition of "investment property" in IAS 40 Investment Property. Once the construction or development is complete, the property becomes investment property and the entity is required to apply IAS 40. IAS 40 also applies to investment property that is being redeveloped for continued future use as investment property. An entity using the cost model for investment property in accordance with IAS 40 shall use the cost model in this Standard.

Source : International Accounting Standard (IAS) 16 Property, Plant and Equipment

How IAS 16 regulates the recognition of PPE

IAS 16 Property, Plant and Equipment paragraph 7 to 14 regulates the recognition of PPE.

Recognition Principle (par. 7) - the cost of an item of property, plant and equipment shall be recognized as an asset if, and only if : (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably.

Spare parts and servicing equipment are usually carried as inventory and recognized in profit and loss as consumed. However, major spare parts and stand-by equipment qualify as PPE when an entity expects to use them during more than one period.

Similarly, if the spare parts and servicing equipment can be used only in connection with an item of PPE, they are accounted for as property, plant and equipment.

This Standard does not prescribe the unit of measure of recognition, i.e. what constitutes an item of PPE. Thus, judgment is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value.

An entity evaluates under this recognition principle all its PPE costs at the time they incurred. These costs include costs incurred initially to acquire or construct an item of PPE and costs incurred subsequently to add to, replace part of, or service it.

Initial Costs

Items of PPE may be acquired for safety or environment reasons. The acquisition of such PPE, although not directly increasing the future economic benefits of any particular existing item of PPE, may be necessary for an entity to obtain the future economic benefits from its other assets.

Such items of PPE qualify for recognition as assets because the enable an entity to derive future economic benefits from related assets in excess of what could be derived had those items not been acquired.

For example, a chemical manufacturer may install new chemical handling process to comply with environmental requirements for the production and storage of dangerous chemicals; related plant enhancements are recognized as an asset because without them the entity is unable to manufacture and sell chemicals. However, the resulting carrying amount of such an asset and related assets is reviewed for impairment in accordance with IAS 36 Impairment of Assets.

Subsequent Costs

Under the recognition principle in par. 7, an entity does not recognize in the carrying amount of an item of PPE the costs of the day-to-day servicing of the item. Rather, these costs are recognized in profit or loss as incurred.

Cost of day-to-day servicing are primarily the costs of labor and consumables, and may include the cost of small parts. The purpose of these expenditures is often described as for the ‘repairs and maintenance’ of the item of PPE.

Parts of some items of PPE may require replacement at regular intervals. Items of PPE may also be acquired to make a less frequently recurring replacement, such as replacing the interior walls of a building, or to make a nonrecurring replacement.

Under the recognition principle in par. 7, an entity recognizes in the carrying amount of an item of PPE the cost of replacing part of such an item when that cost is incurred if the recognition criteria are met.

The carrying amount of those parts that are replaced is derecognized in accordance with the de-recognition provisions of this Standard (as regulates in par. 67-72).

A condition of continuing to operate an item of PPE (for example, an aircraft) may be performing regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognized in the carrying amount of the item of PPE as a replacement if the recognition criteria are satisfied.

Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognized. This occurs regardless of whether the cost of the previous inspection was identified in the transaction in which the item was acquired or constructed.

If necessary, the estimated cost of a future similar inspection may be used as an indication of what the cost of the existing inspection component was when the item was acquired or constructed (Hrd) ***

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

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)