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 with International Financial Reporting Standards (IFRS®). The main IFRS standard that will be discussed is IAS® 16, Property, Plant and Equipment. It also summarises the provisions of IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
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 that have a similar nature or function within the business. For example, properties would typically be one class of assets, and plant and equipment 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 their 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 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 gains are normally recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus. However, if they reverse revaluation losses on the same asset that were previously recognised in the statement of profit or loss then the revaluation gain is recognised in the statement of profit or loss to the extent that it reverses the revaluation loss. Revaluations change the depreciable amount of an asset so subsequent depreciation charges are also affected.
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.
Explain how the revaluation will be accounted for and calculate the annual depreciation charge from 1 January 20X5 onwards.
The revaluation surplus of $900,000 ($2.8m – $1.9m) is recognised in the statement of financial position by crediting the revaluation surplus in equity and recognising the gain in other comprehensive income. Similarly, 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 useful life will be 45 years (50 years from 1 January 20X0 less five years already passed). Therefore, the depreciation charge from 20X5 onwards would be $30,000 ($1.35m x 1/45).
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 – $20,000). IAS 16 allows (but does not require) entities to make a transfer of this ‘excess depreciation’ from the revaluation surplus directly to retained earnings. This annual transfer would be presented in the statement of changes in equity.
Revaluation losses are recognised in the statement of profit or loss. The only exception to this rule is where a revaluation surplus exists relating to a previous revaluation of that asset. To that extent, a revaluation loss can be debited to the revaluation surplus and recognised as a loss in other comprehensive income.
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.
Calculate the revaluation loss and explain how it should be treated in the financial statements.
The carrying amount of the property at 31 December 20X6 would have been $2.74m ($2.8m – ($30,000 x 2 years)). This means that the revaluation deficit 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 you cannot 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 loss 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 balance on the revaluation surplus at 31 December 20X6 would be $880,000 ($900,000 – (2 x $10,000)). Therefore $880,000 would be deducted from equity by reducing the revaluation surplus and $360,000 ($1.24m – $880,000) charged to the statement of profit or loss.
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. No recycling (transfer) of this balance into the statement of profit or loss is permitted.
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.
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:
All of these 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 substantial items of plant and equipment. The normal disposal or scrapping of 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):
Property, plant and equipment
Investments in equity instruments
Cash and cash equivalents
Non-current assets classified as held for sale
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 is below the current carrying amount, then the asset is written down to fair value less costs to sell 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 sale.
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 fair value less costs to sell is estimated at $550,000. The asset was sold for $555,000 on 30 November 20X6. The year end of the entity is 31 December 20X6. The PPE had not previously been revalued.
(a) Explain how the classification as held for sale, and 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 figures remaining the same?
(a) On 30 September 20X6, the asset would be written down to its fair value less costs to sell of $550,000 and an impairment loss of $50,000 ($600,000 – $550,000) recognised in 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 sale of $5,000 would be recognised 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. When the asset is sold on 30 November 20X6, a gain on sale of $55,000 would be recognised.
Where an asset is 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 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.
An asset being classified as held for sale is currently carried under the revaluation model at $600,000. Its fair value has now been estimated as $700,000 and the estimated costs of selling the asset are $10,000.
Explain how this transaction would be recorded in the financial statements.
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 gain 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 would then be written down to this value (being lower than the updated carrying amount) and a $10,000 impairment charged to the statement of profit or loss.
Written by a member of the Financial Reporting examining team