Part 2: Revaluation and derecognition

This is the second of three articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition in accordance IFRS^® Accounting Standards. The main Standard to be discussed is IAS 16 Property, Plant and Equipment. We will also briefly address IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

Revaluation of PPE – IAS 16 position

General principles
IAS 16 allows entities the choice of two measurement models for PPE – the cost model or the revaluation model. Each model needs to be applied consistently to all PPE of the same ‘class’. A class of assets is a grouping of assets which have a similar nature or function within the business. For example, properties would typically be one class of assets; plant and equipment is another. Entities may further classify ‘plant and equipment’ into smaller classes (eg motor vehicles, computer equipment, machinery, etc.)

When the revaluation model is used, assets are carried at fair value, defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. The frequency of revaluations will depend on the changes in fair values of the items of PPE being revalued. If the PPE is subject to significant and volatile changes in fair value, then annual revaluations may be required. Where this is not the case, it may only be necessary to revalue the item, for example, every three or five years.

If an item of PPE is revalued, the entire class of PPE to which that asset belongs must be revalued. However, IAS 16 allows that a class of assets may be revalued on a rolling basis provided the revaluation of the entire class of assets is completed within a short period of time and kept up to date. For example, one third of a property portfolio might be revalued each year so that over a three-year period the whole portfolio is revalued.

Revaluation increases
Revaluation increases (or gains) are normally recognised in other comprehensive income and accumulated in equity in the ‘Revaluation surplus’. However, in the more complex scenario that a revaluation increase reverses a historic revaluation decrease on the same asset (ie previously recognised loss in the statement of profit or loss) then the revaluation increase is recognised in the statement of profit or loss to the extent that it reverses the historic revaluation decrease. Revaluations change the depreciable amount of an asset and so subsequent depreciation charges are also affected.

EXAMPLE 1 
A property was purchased on 1 January 20X0 for $2m. The estimated depreciable amount, excluding the land, was $1m and it had an estimated useful life of 50 years. Annual depreciation of $20,000 was charged from 20X0 to 20X4 inclusive and, on 1 January 20X5, the carrying amount of the property was $1.9m. The property was revalued to $2.8m on 1 January 20X5. The depreciable amount, excluding land, at that date was estimated to be $1.35m and the estimated useful life was unchanged.

Required
Explain how the revaluation will be accounted for and calculate the annual depreciation charge from 1 January 20X5 onwards.

Solution
The revaluation increase of $900,000 ($2.8m fair value - $1.9m carrying amount) is recognised in the statement of financial position by crediting the revaluation surplus in equity and recognising the gain in other comprehensive income. Furthermore, this amount would be shown in the statement of changes in equity under the revaluation surplus heading. The corresponding debit is to PPE and, at 1 January 20X5, the property would have a new carrying amount of $2.8m. The depreciable amount of the property is now $1.35m and the remaining estimated remaining useful life is 45 years (50 years from 1 January 20X0 less five years to 1 January 20X5 already passed). Therefore, the annual depreciation charge from 20X5 onwards would be $30,000 (1/45 years × $1.35m).

A revaluation usually increases the annual depreciation charge in the statement of profit or loss. In the above example, the annual increase is $10,000 ($30,000 depreciation on fair value - $20,000 depreciation on historic cost). IAS 16 allows (but does not require) entities to make a transfer of this ‘excess depreciation’ from the revaluation surplus to retained earnings. Annual transfers are presented in the statement of changes in equity.

Revaluation decreases 
Revaluation decreases (or losses) are recognised initially in the statement of profit or loss. The exception to this rule is where a revaluation surplus exists due to a historic revaluation increase for that same asset. To that extent, a revaluation decrease can be debited to the revaluation surplus and recognised as a loss in other comprehensive income. The amount that can be debited to the revaluation surplus may not exceed the carrying amount after cumulative annual transfers to retained earnings, where relevant.

EXAMPLE 2 
The property referred to in Example 1 was revalued again on 31 December 20X6. Its fair value at that date had fallen to $1.5m.

Required
Calculate the revaluation decrease and explain how it should be treated in the financial statements.

Solution
The carrying amount of the property at 31 December 20X6 would have been $2.74m ($2.8m - [2 years × $30,000]). This means that the revaluation decrease is $1.24m ($2.74m - $1.5m).

If the transfer of excess depreciation (see above) has not been made, then the balance in the revaluation surplus relating to this asset is unchanged at $900,000 (see Example 1). Therefore $900,000 is deducted from equity by reducing the revaluation surplus and the balance of the loss of $340,000 ($1.24m - $900,000) is charged to the statement of profit or loss. It is important to appreciate that, for PPE, you may not create a debit balance on the revaluation surplus. Once you have utilised the revaluation surplus relating to that specific asset and reduced it to nil, any excess revaluation decrease must be debited to profit or loss.

If the transfer of excess depreciation had been made since the property was revalued on 1 January 20X5, then the carrying amount of the revaluation surplus at 31 December 20X6 would be $880,000 ($900,000 - [2 years × $10,000]). Therefore, this balance of $880,000 would be deducted from equity by reducing the revaluation surplus and $360,000 ($1.24m - $880,000) must be charged to the statement of profit or loss.

Derecognition of PPE – IAS 16 position

PPE should be derecognised (removed from PPE) either on disposal or when no future economic benefits are expected from its use or disposal. A gain or loss on disposal is recognised as the difference between the disposal proceeds and the carrying amount of the asset at the date of disposal. This gain or loss is included in the statement of profit or loss – the disposal proceeds should not be recognised as revenue.

Where assets are measured using the revaluation model, any remaining balance in the revaluation surplus relating to the asset disposed of is transferred directly to retained earnings and would be presented in the statement of changes in equity. ‘Recycling’ (ie transferring) this balance to the statement of profit or loss is not permitted.

Disposal of assets – IFRS 5 position

IFRS 5 is another standard that deals with the disposal of non-current assets and discontinued operations. An item of PPE becomes subject to the provisions of IFRS 5 (rather than IAS 16) if it is classified as held for sale. This classification can either be made for a single asset or for a group of assets (disposal group). This article considers the implications of disposing of a single asset only.

IFRS 5 is only applied if the held for sale criteria are satisfied. An asset is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use. For this to be the case, the asset must be available for immediate sale in its present condition and its sale must be highly probable. For a sale to be highly probable in accordance with IFRS 5, it must meet the following criteria:

• an appropriate level of management must be committed to a plan to sell the asset
• an active programme to locate a buyer and complete the plan must have been initiated
• the asset must be actively marketed at a price that is reasonable in relation to its current fair value, and
• a successful sale should normally be expected within one year of the date of classification.

All criteria must be met for the asset to be classified as held for sale.

The types of asset that would typically satisfy the above criteria would be property and very significant items of plant and equipment. The disposal or scrapping of less significant item plant and equipment towards the end of its useful life would be subject to the provisions of IAS 16. When an asset is classified as held for sale, IFRS 5 requires that it be classified separately from all other assets on the statement of financial position under the heading – ‘non-current assets held for sale’.

The illustrative example below shows how this might be presented in a company’s statement of financial position (figures invented):

Once an asset has been classified as being held for sale, no further depreciation is charged as its carrying amount will be recovered principally through sale rather than continuing use.

The existing carrying amount of the asset is compared with its ‘fair value less costs to sell’ (ie the expected selling price less any expected selling costs). If fair value less costs to sell (FVLCTS) is below the current carrying amount, then the asset is written down to FVLCTS and an impairment loss recognised in profit or loss. When the asset is sold, any difference between the new carrying amount and the net selling price is shown as a gain or loss on disposal.

EXAMPLE 4
An item of PPE has a carrying amount of $600,000. It is classified as held for sale on 30 September 20X6. At that date its FVLCTS is $550,000. The asset was sold for $558,000 on 30 November 20X6. The year end of the entity is 31 December 20X6. The PPE had not previously been revalued.

Required
(a) Explain how both the classification as held for sale and the subsequent disposal would be treated in the 20X6 financial statements?
(b) Explain how the above answer would differ if the carrying amount of the asset at 30 September 20X6 was $500,000, with all other amounts remaining the same?

Solution
(a) On 30 September 20X6, the asset would be written down to its FVLCTS of $550,000 and an impairment loss of $50,000 ($600,000 carrying amount - $550,000 FVLCTS) recognised in the operating category of the statement of profit or loss. The asset would be removed from non-current assets and presented in ‘non-current assets held for sale’. On 30 November 20X6 a gain on disposal of $8,000 ($558,000 proceeds - $550,000 carrying amount) would be recognised in the operating category of the statement of profit or loss, and the asset derecognised.

(b) On 30 September 20X6 the asset would be transferred to non-current assets held for sale at its existing carrying amount of $500,000 (ie, it is less than FVLCTS). When the asset is sold on 30 November 20X6, a gain on sale of $58,000 would be recognised in the operating category of the statement of profit or loss.

Where an asset is subsequently measured under the revaluation model then IFRS 5 requires that its revaluation must be updated immediately prior to being classified as held for sale. The effect of this treatment is that the selling costs will always be charged to the operating category of the statement of profit or loss at the date the asset is classified as held for sale, because the carrying amount will already have been updated to its fair value immediately before the transfer.

EXAMPLE 5
An asset meets the criteria for being classified as held for sale and is currently measured using the revaluation model, at $600,000. Its fair value is now $700,000 immediately prior to reclassification and the estimated costs of selling the asset are $10,000.

Required
Explain how this transaction would be recorded in the financial statements.

Solution
Immediately prior to being classified as held for sale, the asset would be revalued to its fair value of $700,000 in accordance with IAS 16. The revaluation increase of $100,000 would be credited to the revaluation surplus and presented in other comprehensive income. The fair value less costs to sell of the asset is $690,000 ($700,000 - $10,000). On reclassification, as a non-current asset held for sale, the asset is written down to its FVLTCS and a $10,000 impairment (ie the selling costs) is charged to the statement of profit or loss

Written by a member of the Financial Reporting examining team