Question related to IAS 16

[israrhere]

Dear Sir Kamran please explain the procedure to be followed according to para 35 and 41 of the revaluation model.
And when will be the depreciaiton charge added to the cost of other assets instead of charging to profit and loss?
Thanks

[kamranACA]

Dear Israr,


I wrote answer of almost two pages that has been deleted by internet fluctuation (

Let's see some other time now.


Regards,


Kamran.

[israrhere]

How unlucky......but Its ok sir no problem...whenever you get time please have a look again.Thanks for considering the question.

[israrhere]

Salam dears...Is there anyone else having a little free time to please help me out regarding above concept........
thanksssssssss

[Astute Accountant]

Well, I could have explianed it the very next day, you had posted your query but I worry my explanation won't be as illustrative as Kamran Bhai's. Secondly, I thought that you might be interested in comprehensive details so I refrained.......

[israrhere]

Thanks dear Astute for your reply.Actually I am overhere in my hometown now a days, so am not able to avail the help of my teachers.
I mentioned the name of Sir Kamran for the reason that he usually helps in such sort of queries and he did but unfortunately...
Anyways now I don't need dat much comrehensive details but just to clear my concept a bit and ofcourse you can do it,so please..........

[Astute Accountant]

<b> Objective of IAS 16 </b>

The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and equipment. The principal issues are the timing of recognition of assets, the determination of their carrying amounts, and the depreciation charges to be recognised in relation to them.

<b> Scope </b>

While IAS 16 does not apply to biological assets related to agricultural activity (see IAS 41) or mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources, it does apply to property, plant, and equipment used to develop or maintain such assets. [IAS 16.3]

<b> Recognition </b>

Items of property, plant, and equipment should be recognised as assets when it is probable that [IAS 16.7]

the future economic benefits associated with the asset will flow to the enterprise; and
the cost of the asset can be measured reliably.
This recognition principle is applied to all property, plant, and equipment costs at the time they are incurred. These costs include costs incurred initially to acquire or construct an item of property, plant and equipment and costs incurred subsequently to add to, replace part of, or service it.

IAS 16 does not prescribe the unit of measure for recognition – what constitutes an item of property, plant, and equipment. [IAS 16.9] Note, however, that if the cost model is used (see below) 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 must be depreciated separately. [IAS 16.43]

IAS 16 recognises that parts of some items of property, plant, and equipment may require replacement at regular intervals. The carrying amount of an item of property, plant, and equipment will include the cost of replacing the part of such an item when that cost is incurred if the recognition criteria (future benefits and measurement reliability) are met. The carrying amount of those parts that are replaced is derecognised in accordance with the derecognition provisions of IAS 16.67-72. [IAS 16.13]

Also, continued operation of an item of property, plant, and equipment (for example, an aircraft) may require regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant, and equipment as a replacement if the recognition criteria are satisfied. 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. [IAS 16.14]

<b> The Revaluation Model </b>

The asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation, provided that fair value can be measured reliably. [IAS 16.31]

Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31]

If an item is revalued, the entire class of assets to which that asset belongs should be revalued. [IAS 16.36]

Revalued assets are depreciated in the same way as under the cost model (see below).

If a revaluation results in an increase in value, it should be credited to equity under the heading "revaluation surplus" unless it represents the reversal of a revaluation decrease of the same asset previously recognised as an expense, in which case it should be recognised as income. [IAS 16.39]

A decrease arising as a result of a revaluation should be recognised as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus relating to the same asset. [IAS 16.40]

When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer to retained earnings should not be made through the income statement (that is, no "recycling" through profit or loss). [IAS 16.41]

[Astute Accountant]

And the depreciation charge is added to the carring amount of other assets when permitted. (But I'm not sure, in which cases it is permitted ( So....can't explain. )

[kamranACA]

Dear Israr,


My earlier reply was much detailed where i also gave all the prototype accounting entries, by suggesting a supposed case study, but now for your clarification I just go in brief.

I let u to understand practically what happens.

When revaluation is made it is made either to change the cost model to revaluation model or to have a fresh revaluation if this model is already in practice (with reasonable frequency as IAS 16 suggests) and incorporate its accounting effects as per IAS 16 (in Pakistan as per section 235 of Companies Ordinance 1984).

However there is no major difference in such accounting treat for both above situations.

Further, when we change the measurement model from cost to revaluation, we have to give detailed disclosures only as required by IAS 16 but it would not be treated as a change in accounting policy under IAS 8. There would be no adjustment in opening retained earnings and no retrospective application will be made. See paragraph 17 of IAS 8.

Further to above, section 235 of CO 84 suggests different treatment for the surplus arising out of revaluation which does not agree to IAS 16 in so far as it relates to its categorization, usage and increase or decrease due to subsequent revaluation, is concerned. However, this does not have any impact on treatment of addition/deduction to / from the value of assets revalued; means its (assets side) treatment would remain same.

From 2003 (probably) the CO 84 has also been changed so as to allow the practice of charging incremental depreciation on revaluation surplus (para 41 of IAS 16 and SRO 45 issued by SECP).

This was background. Now coming to ur issues.

Paragraph 35 of IAS 16

Whenever you apply revaluation model (either first time or as a practice) you have two figures of any item of property plant and equipment (PPE) i.e. cost / appreciated value (also known as gross carrying value) and accumulated depreciation. The net figure which is taken to balance sheet is called book value or written down value or net carrying value or simply carrying value. The entity which gets its PPE items revalued, will adjust the accumulated depreciation against its cost (or appreciated value, if this model was already adopted) and calculate the carrying values. Then it will add revaluation surplus arising against each item in the outstanding carrying value (calculated as above) of PPE items and get the revalued figures to be shown in the balance sheet. The brief accounting entry to tally both credit and debit sides would be

......... PPE items carrying value (DEBIT)
.........................Surplus on revaluation of PPE (CREDIT)

Practically, in whole of Pakistan the same practice is adopted and in fact the both treatments given in IAS 16 Paragraph 35 a and 35 b are aimed at same result. You can check it in practice. In both cases, the ultimate carrying amount will be raised to the revalued amount. Only presentation can differ that either you add back accumulated depreciation proportionately in gross carrying value or you set off depreciation against gross carrying value and then separately add revaluation amounts in it.

Please note that, in practice, revaluation is normally made on any specific date when some financial statements are prepared say quarter end, half year end or year end. In any case depreciation will not be charged on adjusted figures. Means, until the end of that period depreciation will be charged on existing values (before adding the revaluation surplus) and net carrying values taken by the independent valuer will be the net carrying values arrived at after charging depreciation for the period before revaluation date. This is very important to understand.

Say a revaluation of PPE item is made on 30 June 2007 i.e. after the close of the whole year then ended (2006-2007). The cost / gross carrying amount before such revaluation was Rs 100, opening accumulated depreciation was Rs 50 and depreciation for the year ended 30 June 2007 (before revaluation) was Rs 5, closing accumulated depreciation was Rs 55 and revalued amount was suggested by independent valuer as Rs. 85 thus arising a surplus on revaluation of Rs 40 as at 30 June 2007.

In this situation, Rs 5 the depreciation for the year was based upon the figures before revaluation. In no case depreciation could be charged on revalued amounts. Why? Becoz revaluation is always made as of a certain date. In this case it has been made as at 30 June 2007. So, as at 30 June 2007 the fair value would be the value arriving at after incorporating revaluation surplus on each item of PPE, i.e. Rs 85. If we will not do this and will charge for the year depreciation after incorporating the revaluation, then it will decrease the net carrying values below the fair value determined by the valuer. This would be wrong. Therefore whenever a revaluation is made, it is always a date specific, and valuer always requires such net carrying values for calculating surplus against each item. However, from the next period, depreciation would be charged on revalued figures.

I hope you would be able to understand para 35. If you have queries, please let me know.

Now coming to your second query concerning paragraph 41.

IAS 16 states that whenever a revalued item of PPE is sold the particularly relating surplus lying at credit (equity side) of the balance sheet will be transferred from “Revaluation surplus” account to “Un-appropriated profit account” that’s also called as retained earnings. This surplus is basically a realized amount upon sale of PPE item but would not be routed through profit and loss account. For example an item having gross carrying amount of Rs 10, accumulated depreciation of Rs 3, net carrying amount of Rs 7 having a surplus lying on equity side amounting to Rs 4 is sold at Rs 12. Following entry would be passed

First entry

…………………..Cash / account receivable against sale (DEBIT) 12
…………………..Accumulated depreciation (DEBIT) 3
………..Gross carrying amount (CREDIT) 10
…….… Gain on sale of PPE (profit and loss account) (CREDIT) 5

Second entry

…………………..Surplus on revaluation (DEBIT) 4
……..........Retained earnings (CREDIT) 4


Hope this part of paragraph 41 is clear now. (However, as per CO84 such realized surplus has to be routed through profit and loss account instead of a direct transfer).

Now the second issue, i.e. realization of surplus on use of an item of PPE. This means that when an item of PPE is revalued, the onward depreciation is charged on revalued amounts i.e. which would be higher than the depreciation based upon actual cost of such assets due to revaluation portion.

Due to this IAS 16 requires that incremental depreciation (excessive portion of depreciation due to revaluation) will be transferred from Revaluation Surplus account to retained earnings account………. [Every entity has to maintain separate record of assets on cost basis and on revaluation basis, as certain disclosures are required by IAS 16 which cannot be made without it.]……… Say net carrying amount on cost basis, of an item was Rs 150 and on revaluation basis was Rs 200, then there would be a difference in depreciation expense due to revaluation i.e. on cost basis depreciation expense could be Rs 15 while on revaluation basis it could be Rs 20. Certainly, as the revaluation has been made, the expense to be charged in profit and loss account will be Rs 20 and not Rs 15 thus having a difference of Rs 5 which is due to revaluation.

IAS 16 requires that this difference of Rs 5 should be realized / transferred from Revaluation Surplus account to Retained earnings account. Again as per IAS 16 it is not to be routed through profit and loss account. [However, in this case CO 84 also have same requirement and does not allow to route through profit and loss account].

There are certain implications of deferred tax on revaluation surplus and this incremental depreciation, which I am skipping in this discussion.

Rest of issues are clarified by astute.

\Hope you would be benefited. If you have queries, write the same on the forum.


Regards,



Kamran.

[israrhere]

Thank you very much for so much comprehensive and helpfull explanantions...

Israr.

[kamranACA]

Dear Astute,

<blockquote id="quote"><font size="1" face="Verdana, Tahoma, Arial" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by Astute Accountant</i>
<br />And the depreciation charge is added to the carring amount of other assets when permitted. (But I'm not sure, in which cases it is permitted ( So....can't explain. )
<hr height="1" noshade id="quote"></font id="quote"></blockquote id="quote">


Depreciation charge can be capitalized in the cost of some qualifying asset. The example could be given of the electrification of colonies and villages/cities by KESC and WAPDA. In such electricfication heavy machinery and equipment is used by these entities. Further, some specific offices are allocated which do not do anything else except for such capital works. The depreciation of such heavy machinery. equipment and offices (including its fixture and other assets) could be capitalized (on some prorate basis) as part of Electrical Assets capitalized as a result of such electrifiation.


There could be so many other examples like plaza building, excavation of wells, initial mining and construction process etc, in the cost of which the depreciation of those assets which were used in the building process, can be capitalized.


Regards,


KAMRAN.

[villya]

to mr.astute and mr kamran.
if you dont mind, i want to ask several question according to this concept.
is there any consideration to choose whether to use cost models or revaluation models?
is there any type of assets that revaluation or cost models cant be applied?
why do people use revaluation rather than cost, and vice versa?
thank you.

regards,

Lya

[kamranACA]

Lya,

There could be a number of reasons for choosing revaluation model instead of cost model or visa. Jurisdiction specific legal requirements associated with financing and loaning may also affect such decision.

However, there are two basic reasons which count while making such decision. The "historical cost convention" is being taken over by "fair value convention" with the passage of time. We see that all financial instruments (either liabilities or assets) are to be valued at fair value or at amortised cost that should also be fair value deriven amortised cost (IAS-39). All provisions have to be reviewed and updated as at balance sheet date as required by IAS 37 (i.e. that latest fair assessment). All defined benefit plan obligations have to be valued by actuaries based upon fair value based assumptions, deferred tax asset and deferred tax liability has to be assessed at each balance sheet date and impairment of every asset has to be assessed as at the reporting dates to reflect the prudent figures.

The fair valuation concept coupled with impairment assessment (prudence concept) has lead the world at large to think about presenting the accounts prudently on fair values. You will see that this concept will keep on capturing every component of financial reporting. However, it is sensibly different than the concept of stating the financial results and position on current values, a concept that was previously given by an IAS that has now been withdrawn.

So, the people who find it more appropriate to state the figures on prudent fair values, tend to use revaluation model.

Revaluation, which normally results in increased values, also strengthens the equity structure and improves the net worth of the entity without getting further contribution from equity owners. This gives an advantageous position while calculating DebtEquity ratio, which parameter, is used by financial institutions and banks at large, to decide about extending debt facilities. The improved equity means advantageous position in getting finance for long term and short term financing. In Pakistan, banks normally require debt equity ratio of 6040 for lending the debt (except for some specific industries where this ratio is relaxed). I don't know how banking system at Indonesia works.

People tend to opt cost model where they feel that changes to the values are not so material or where they feel the outcome may not be so beneficial when compared to the efforts or costs being incurred.

This is just a reason. However, IAS-16 provides liberty between the two options and an entity may use any one without giving any explanation for the causes and reasons.

To my knowledge there is no asset (in Property, plant and equipment category) that cannot be revalued. I understand revaluing mining resources and assets may be quite difficult but IAS-16 has not highlighted any exception.

Regards,


KAMRAN.

[smraza]

Kamran,
I would like to add a little bit, when the assets are carried using the cost model always have a option to use the revaluation model, but the assets once carried at revalued model, the options of using the cost model is closed.
what do you say.

[kamranACA]

Dear Smraza,

It is not the case. If an entity states its PPE under revaluation model, it can get back to the Cost model merely by changing the accounting policy. Paragraph 29 of IAS-16 states that any one of two models could be used as accounting policy. Since every accounting policy could be changed (within permitted framework), there is no bar on getting back to cost model if revaluation model was previously opted. We may see entities which present some classes of PPE uner cost model and other under Revaluation model at the same time.

Requirement is to revlaue entire class of PPE items if for that class Revaluation model has to be used. It means if freehold land is decided to be shown under revaluation model, you can not leave some pieces of land on cost and select some pieces of land to be revalued. You will have to revalue the entire class i.e. all the freehold lands you own. However, you are at liberty to show freehold land under revlauation model and building under cost model simultaneously.

As far as changing of policy from revaluation model to cost model is concerned, you can see number of examples in the years 2004 and 2005 when SRO 45 (revising section 235 of CO84) was issued by SECP suggesting the treatment of incemental depreciation and involving adjustments of related deferred tax, which concept was not followed in Pakistan due to overriding differnce in section 235 of the CO84. After that revision of law an emphasis was given on fresh revaluations with regular frequency (that is required by IAS 16) which prompted so many units to re-opt the cost model.

I would like to mention that initial application of a policy requiring the use of revlauation model instead of cost model has not to be treated under IAS-8. I refer paragraph 17 of IAS-8 in this regard. However, the change of accounting policy from revlauation model to cost model would be under IAS-8, as per my understanding.

Regards,


KAMRAN.