Revaluation/Impairment Unit 11

Revaluation/impairment unit 11

reddwarf wrote: »

Would someone please explain the difference and which assets and valuation models are subject to revaluationand/or impairment please?

I find the Osborne book has not set this out clearly enough (well not for me anyway!?).

Any help appreciated!

Under IAS16 (Property Plant & Equipment), non-current assets in these categories are initially recognised in the statement of financial position using the COST MODEL, i.e. what it cost the business to purchase them in the first place. Cost includes not just the original purchase price but add-on costs incurred in bringing the asset into FIRST use (e.g legal costs of buying a property) and subsequent disposal costs when it is known for certain that the business has an obligation to incur them at the end of the asset's useful economic life.

It is the case that the value of some non-current assets changes over the course of time ; for instance, the value of property may go up or down according to market trends. It is therefore common practice for the business to re-value its assets in the light of such changes. If a business wishes to do this, it can switch from the COST MODEL to the REVALUATION MODEL. However, having switched from the cost model to the revaluation model, it cannot subsequently revert to the cost model even if it appears financially advantageous for it to do so (e.g. if the value of property increases beyond its initial cost in a boom year, then falls below the original cost in a recession year). Revaluation of PPE should be done when there are clear indications that it is needed, e.g. fluctuations in the property market.

A further point that needs to be noted is that one item in a class of non-current assets is revalued, the entire class must be revalued also. You can't just revalue one item of property in isolation and ignore the rest.

The journal entries for a revaluation of a non-current asset are:

DEBIT : Non-current assets
CREDIT : Revaluation reserve

Impairment of a non-current asset occurs when its carrying amount (i.e. the amount at which it is recognised in the statement of financial position) is greater than its recoverable amount. If this situation occurs, the asset is said to be impaired and must be written down to its recoverable amount. Remember, the prudence concept of accounting requires you to be conservative in the valuation of assets, so you have to take due account of impairment.

The recoverable amount of a non-current asset is the HIGHER of:

The fair value (i.e. the value for which the asset could be exchanged in an arm's length transaction involving willing knowledgeable parties), minus direct costs of disposal ; and

The in-use value (the present value of future economic benefits expected to be obtained from continuing use of the asset).

There are two categories of non-current asset that must be tested for impairment annually. These are:

Goodwill acquired in a business combination ; and
Intangible non-current assets (see IAS38)

An asset may become impaired due to a variety of factors. Technical obsolescence and significant damage are two such examples.

Hope this somewhat truncated and simplified narrative goes some way towards answsering your question.

Any business has to take a starting point for recognising its assets on its statement of financial position, so it seems logical that on initial purchanse of an asset, its initial recongition is done on the basis of what it has cost the entity to make the purchase and bring it into first use. If you think about it, there's no other way for initial recognition of first purchases.

Where revaluation comes in is where the value of the asset fluctuates AFTER INITIAL PURCHASE according to market conditions. I use property as an example because, more than most asset categories, its values flcutuate wildly. I bought my own house brand new in 1989 for £60K. By 1994 it was worth only £30K. By 2006 it was worth £150K. It would sell today for about £120K if I was lucky. OK, so I'm not a business but the same principles apply to business premises and you can understand why a business would want to switch between recognition models. If you buy a property for £30K and its value jumps to £150K, wouldn't you want that captured in your accounts by switching to the revaluation model? Well, you can do that, but if there is subsequently a market crash and its market value subsequently fell from £150K to £20K (unlikely but possible) you might want to switch back from revaluation to cost model to reflect the fact that you bought it for £30K - but you can't do that!

The Osborne Book should state that businesses do have a choice in theory about how the initially recognise an item of PPE in the statement of financial position, but it's a theoretical choice only. How in practice are you supposed to value a new car when you first purchase it, other than at what it cost you to buy and commission it?

Investment property is a different ballgame altogether because it's property that is held for capital appreciation or rental income (or both). To capture the effect of capital appreciation you have to recognise the asset initially using what it cost you to buy it, i.e. the cost model. Otherwise how can you subsequently show capital appreciation?

All assets can become impaired during their useful economic life, and many indeed do, and if it happens, they should be written down to reflect this. However, the only compulsion on businesses to test assets for impairment applies to intangible assets and goodwill acquired in a business combination. The IASs dealing with these (IAS38 and IFRS3 respectively) state that an impairment test must be conducted annually. Personally I believe that all material items of PPE should be tested annually for impairment, but that's a personal view of mine, not a mandate from the applicable IAS.

reddwarf wrote: »

Thanks so much for this David! Couple of questions:-

'Under IAS16 (Property Plant & Equipment), non-current assets in these categories are initially recognised in the statement of financial position using the COST MODEL, i.e. what it cost the business to purchase them in the first place. Cost includes not just the original purchase price but add-on costs incurred in bringing the asset into FIRST use (e.g legal costs of buying a property) and subsequent disposal costs when it is known for certain that the business has an obligation to incur them at the end of the asset's useful economic life.'

So the cost model is always used first? The Osborne book does not state this clearly. It states this for Investment Property so I thought for PPE the entity has a choice about initial cost to use. i.e.Cost or Revaluation.

So impairment applies to all non-current assets?

Thanks again