I often talk with many professionals about a practical application of IFRS and the topic of long-term tangible asset is very frequent.
To my surprise I found out that a lot of them believed that with regard to accounting for property, plant and equipment (especially real estate of various kinds), there is just 1 standard – IAS 16, and just 2 models are prescribed:
- Cost model, and
- Fair value model under which you revalue your PPE to fair value and you recognize fair value changes in other comprehensive income.
Let me tell you – this is wrong.
Here, I’d like to correct this misunderstanding and set the record straight.
Myth #1: You have to account for all long-term tangible assets under IAS 16
This is wrong.
There are few IFRS standards to pick from and the selection basically depends on the purpose or reason why you hold an asset.
Be extremely careful here, because sometimes, the classification is NOT that easy and obvious and you need to make judgment in order to pick the right standard.
Short example: which standard to apply?
As an example – last year we visited dolphin show with my kids. While they were observing dolphins dancing in the water, I was thinking about how to account for them (yes, I suffer from “job-related impacts”).
The fact it’s a living animal might suggest that it’s automatically biological asset under IAS 41, but is it really?
Well, no. Here, the dolphins were used primarily for being shown to people and they generated income from fees paid by these people – this is NOT an agricultural activity and as a result, IAS 41 does NOT apply. Yes, you guessed that – here, IAS 16 applies.
But, if the company would have bred the dolphins in order to get their offspring (children) and sell young dolphins, then yes, this would have been an agricultural activity and IAS 41 applies here.
This short example should give you a hint to be a little bit careful and think before you classify your assets.
Which standards can we choose from?
- IAS 16 Property, Plant and Equipment
IAS 16 is probably the first standard catching your attention when you need to decide how to account for your newly acquired piece of long-term tangible asset.
Indeed, if you hold your assets with the purpose of using them in the production of goods or providing services, for rentals to others or administrative purposes, then yes, this one can be the right choice.
- IAS 40 Investment Property
IAS 40 is often an omitted standard, but it gives you a great choice for your buildings or lands held to earn rentals.
Moreover, if you hold your buildings or land for capital appreciation purposes (i.e. making profit from their fair value changes), then you need to apply IAS 40 rather than IAS 16.
- IAS 2 Inventories
This should be no surprise for a seasoned CFO: when you hold some long-term assets in order to sell them in an ordinary course of your business, then they are inventories rather than property, plant and equipment.
For example, car dealers report new cars for resale under “inventories”, and cars for their own use usually under “property, plant and equipment”.
- IAS 41 Agriculture
- IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 5 is here for a very special occasion: as soon as specified conditions are met (i.e. management is committed to a sale, an asset is immediately available for sale, etc.), then you can forget about IAS 16 and other standards.
Instead, you need to focus on IFRS 5.
I’m mentioning this one just to give you the full picture, but here again, think of IAS 41 for all your biological assets used in an agricultural activity (with the new exception of bearer plants).
As you can see, the first question you need to ask when classifying your long-term asset is:
What is the purpose or the reason why we hold this asset?
Myth #2: You can choose only between cost model and fair value model.
This is wrong again.
As I wrote above, there are many standards fitting individual situations and each standard contains at least one model available.
But for a while, let’s forget about assets held for sale, inventories and biological assets. Anyway, most questions I receive related to production assets, especially buildings and lands.
What models are available for the production assets, including buildings and lands?
There are 3 models:
- Cost model under IAS 16;
- Revaluation model under IAS 16; and
- Fair value model under IAS 40.
The most common model is probably the cost model, under which you hold your assets at their cost less accumulated depreciation (less accumulated impairment losses if there are some).
Sometimes, this model does not fit the situation well – for example, when you invested into a building with the purpose of selling it later.
Also, many companies do not apply the cost model properly, as they often forget to revise useful lives of their assets and as a result, they still use fully depreciated assets in the business.
Let me tell you, that with the reference to 2 remaining models, there’s one very common misconception:
Myth #3: The fair value model is the same as the revaluation model.
Wrong!
These models are totally different, although they have one common feature: fair value.
Yet I often hear the wrong statement: “under fair value model, you revalue your assets regularly to their fair value with the changes recognized in other comprehensive income”.
This was a mixture of fair value model and revaluation model.
So what’s the difference?
Revaluation model
Revaluation model is prescribed as an option under IAS 16 Property, Plant and Equipment.
It means that you can apply it for any assets used for more than 1 year in the production process, for rental to others or for administrative purposes, including your buildings or machinery.
Under this model, you should revalue your assets regularly to their fair value and depreciate revalued amount over remaining useful life. When you revalue your assets, the change is recognized in other comprehensive income (with some exceptions).
Here, the important thing is that you can use revaluation model also for machinery (unlike fair value model) and also, you charge depreciation (not under fair value model).
Fair value model
Fair value model is prescribed as an option under IAS 40 Investment Property.
You can apply it only for buildings and lands held either to earn rentals or for capital appreciation (or both).
Under this model, you should value your assets at their fair value after initial recognition, with the fair value changes recognized in profit or loss.
Here, you cannot apply fair value model to your machinery (unlike revaluation model), and also, you do NOT charge any depreciation.
To illustrate the differences between fair value model and revaluation model, let’s solve a small example.
Example: Building and 2 models
On 1 January 20X1, ABC company acquired a building with the total cost of CU 300 000. As of 31 December 20X1, the following information is available:
- Building’s useful life is 30 years.
- Building’s fair value at 31 December 20X1 is CU 310 000.
What accounting entries shall ABC make with respect to this building in 20X1 under:
- Fair value model
- Revaluation model
Building and fair value model
Here, the things are quite simple and easy. ABC simply revalues building to its fair value of CU 310 000 and does not care about the depreciation as there’s none.
The journal entry is:
- Debit Assets – Investment property with CU 10 000 (310 000-300 000); and
- Credit Profit or loss – Fair value gain on investment property with CU 10 000.
Here please note that the building is shown under the heading “Investment property” and not “Property, plant and equipment” and of course, it’s purpose is either to earn rentals or for capital appreciation (otherwise, you cannot apply IAS 40 and fair value model).
Building and revaluation model
Similarly as before, ABC revalues its building to the fair value of CU 310 000.
However, as we are under revaluation model now, some depreciation for 1-year usage in 20X1 should be recognized. The building’s useful life is 30 years, therefore, ABC makes the following journal entries:
Depreciation in 20X1:
- Debit Profit or loss – depreciation with CU 10 000 (300 000 divided by 30 years); and
- Credit Assets – PPE (accumulated depreciation) with CU 10 000.
Revaluation as of 31 December 20X1:
- Debit Assets – PPE with CU 20 000 (Fair value of CU 310 000 less carrying amount of CU 290 000); and
- Credit Equity – revaluation surplus with CU 20 000.
In 20X2, ABC will charge depreciation amounting to CU 10 690 per year, which is calculated as revalued amount of CU 310 000 divided by the remaining useful life of 29 years.
The little trick here is to make a transfer between retained earnings and revaluation surplus in equity amounting to difference in depreciation charges from revalued amount and original cost:
- Debit Equity – Revaluation surplus with CU 690; and
- Credit Retained earnings – depreciation charge with CU 690.
The reason for this transfer is to bring revaluation surplus related to building to zero together with its depreciation over its remaining useful life.
I hope that this article cleared the confusion related to fair value model and revaluation model, plus a couple of other myths related to measurement of long-term tangible assets.
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