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IFT Notes for Level I CFA® Program

R26 Long Lived Assets

Part 4


 

4.  The Revaluation Model

What we have seen so far is the cost model of accounting where an asset is recorded originally at cost. This value is then depreciated every year. An alternative to cost model is the revaluation model. Under the revaluation model, assets are revalued periodically. The carrying value of an asset after revaluation becomes the fair value. The method is used when the fair value of an asset can be easily determined and is subject to judgment.

IFRS permits the use of either the cost model or the revaluation model for the valuation and reporting of long-lived assets, but the revaluation model is not allowed under US GAAP.

Impact of revaluation on financial statements

The impact of revaluation on financial statements depends on whether the revaluation initially increased or decreased the asset class’ carrying amount. Let us consider both the cases.

Downward revaluation

When a revaluation initially decreases the carrying amount of an asset:

  • The decrease is recognized as loss in the income statement.
  • Later, if the asset’s carrying amount increases, the increase is recognized as a gain on the income statement to the extent that it reverses the revaluation decrease previously recognized for the same asset class.
  • Any increase in excess of the reversal amount will not be recognized in the income statement, but will be recorded directly to equity as a revaluation surplus.

Upward revaluation

When a revaluation initially increases the carrying amount of the asset class:

  • An increase in the carrying value of the asset class bypasses the income statement and is recorded directly under equity as a revaluation surplus.
  • A subsequent decrease in the carrying amount first decreases the revaluation surplus and any excess beyond the reversal amount is recorded as a loss on the income statement.

Example

Upward Corp, a hypothetical manufacturing company, has elected to use the revaluation model for its machinery. Assume for simplicity that the company owns a single machine, which it purchased for $20,000 on the first day of its fiscal period, and that the measurement date occurs simultaneously with the company’s fiscal period end.

  1. At the end of the first fiscal period after acquisition, assume that the fair value of the machine is determined to be $22,000. How will the company’s financial statements reflect the asset?
  2. At the end of the second fiscal period after acquisition, assume that the fair value of the machine is determined to be $15,000. How will the company’s financial statements reflect the asset?

Solution to 1:

At the end of the first fiscal period, the company’s balance sheet will show the asset at a value of $22,000. The $2,000 increase in the value of the asset will appear in other comprehensive income and be accumulated in equity under the heading of revaluation surplus.

Note: Gains do not go through income statement and instead go directly to equity under revaluation surplus. In case of loss, part of the decrease is shown as loss in income statement.

Solution to 2:

At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of $15,000. The total decrease in the carrying amount of the asset is $7,000 ($22,000 – $15,000). Of the $7,000 decrease in the carrying amount, $2,000 will reduce the amount previously accumulated in equity under the heading of revaluation surplus. This does not go through the income statement. The other $5,000 will be shown as a loss on the income statement.

 

Example

Downward Corp, a hypothetical manufacturing company, has elected to use the revaluation model for its machinery. Assume for simplicity that the company owns a single machine, which it purchased for $20,000 on the first day of its fiscal period, and that the measurement date occurs simultaneously with the company’s fiscal period end.

  1. At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be $15,000. How will the company’s financial statements reflect the asset?
  2. At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be $22,000. How will the company’s financial statements reflect the asset?

Solution to 1:

At the end of the first fiscal period, the company’s balance sheet will show the asset at a value of $15,000. The $5,000 decrease in the value of the asset will appear as a loss on the company’s income statement.

Solution to 2:

At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of $22,000. The total increase in the carrying amount of the asset is an increase of $7,000 ($22,000 – $15,000). Of the $7,000 increase, $5,000 goes towards reversal of a previously reported loss and will be reported as a gain on the income statement. The other $2,000 will bypass profit or loss and be reported as other comprehensive income and be accumulated in equity under the heading of revaluation surplus.

5.  Impairment of Assets

Impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount (Whereas depreciation and amortization charges allocate the cost of a long-lived asset over its useful life.)

Under IFRS

  • An asset is impaired when its carrying value exceeds the recoverable amount.
  • The recoverable amount is the greater of (fair value less selling costs) and the (present value of expected cash flows from the asset, i.e., the value in use).
  • If impaired, the asset is written down to the recoverable amount.
  • Subsequent loss recoveries are allowed, but they cannot exceed the historical cost.

Under US GAAP,

  • An asset is impaired if its carrying value is greater than the asset’s undiscounted future cash flows.
  • If impaired, the asset is written down to the fair value.
  • Subsequent loss recoveries are not allowed.

Impairments of assets result in losses in the income statement. However, they have no impact on the cash flow.

Example

Given the following data, what is the reported value under IFRS and US GAAP:

  • Carrying amount = $8,000
  • Undiscounted expected future cash flows = $9,000
  • Present value of expected future cash flows = $6,000
  • Fair value if sold = $7,000
  • Costs to sell = $200

Solution:

IFRS: Recoverable amount = greater of ($7,000 – $200, $ 6,000) = $6,800

Impairment loss = $8,000- $6,800 = $1,200

Write down the value of asset from $8,000 to $6,800 in the balance sheet and record a loss of $1,200 in the income statement.

US GAAP: Is the asset impaired? No, since the carrying amount of $8,000 is less than the undiscounted future cash flows of $9,000.

Other Impairment Scenarios

Impairment of Intangible Assets with Indefinite Lives: Intangible assets with infinite lives such as goodwill are not amortized. They are carried on the balance sheet at historical cost, but they are tested annually for impairment.

Impairment of Long–Lived Assets Held for Sale: A long-lived asset is reclassified as held for sale, if the management’s intent is to sell it and its sale is highly probable. For example, if a company owns a machine with the intent of using it but now intends to sell it, then it should be reclassified as held for sale. Held-for-sale assets are not depreciated or amortized. At the time of reclassification, the asset should be tested for impairment and any impairment loss should be recognized.

The impairment loss can be reversed under IFRS and US. GAAP if the value of the asset recovers in the future. However, this reversal is limited to the original impairment loss. Therefore, the carrying value of the asset after reversal cannot exceed the carrying value before the impairment was recognized.

6.  Derecognition

A company derecognizes an asset (i.e., removes it from the financial statements) when the asset is disposed of or is expected to provide no future benefits from either use or disposal.

The three ways in which an asset can be derecognized (removed from a company’s financial statements) are as follows:

  • Selling the asset: The difference between the sales proceeds and the carrying value of the asset is reported as a gain or loss on the income statement.
  • Abandoning the asset: The carrying value of the asset is removed from the balance sheet and a loss is recognized in that amount in the income statement.
  • Exchanging the asset: The carrying value of the old asset is compared to the fair value of the new asset and a gain or loss is reported.
  • Distributed to owners in a spin-off: In a spin-off, typically, an entire cash generating unit of a company with all its assets is spun off and does not result in any gain or loss.

7.  Presentation and Disclosures

Under IFRS, for each class of property, plant, and equipment, a company must disclose the measurement bases, the depreciation method, the useful lives (or, equivalently, the depreciation rate) used, the gross carrying amount, the accumulated depreciation at the beginning and end of the period, and a reconciliation of the carrying amount at the beginning and end of the period.

Under U.S. GAAP, the requirements are less exhaustive. A company must disclose the depreciation expense for the period, the balances of major classes of depreciable assets, accumulated depreciation by major classes or in total, and a general description of the depreciation method(s) used in computing depreciation expense with respect to the major classes of depreciable assets.

The disclosures related to impairment losses also differ under IFRS and US GAAP. Under IFRS, a company must disclose for each class of assets the following:

  • The amounts of impairment losses and reversals of impairment losses recognized in the period and where those are recognized on the financial statements.
  • The main classes of assets affected by impairment losses and reversals of impairment losses and the main events and circumstances leading to recognition of these impairment losses and reversals of impairment losses.

Under US GAAP, reversal of impairment losses for assets held for use is not permitted. The company must disclose the following:

  • The description of the impaired asset, what led to the impairment;
  • The method of determining fair value;
  • The amount of the impairment loss, and where the loss is recognized on the financial statements.

8.  Investment Property

Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals, capital appreciation, or both.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment, but the fair value model differs from the revaluation model used for property, plant, and equipment. Under the fair value model, all changes in the fair value of investment property affect net income.

Under U.S. GAAP, investment properties are generally measured using the cost model.


FRA Long-Lived Assets Part 4