Question

Please introduce yourself and the purpose of your presentation. Speak slowly and clearly to address each of the following:

Issue 1: You are the accountant for a small accounting firm, Zandy Pty Ltd. A client, Tom Jones has just emailed you with great confusion over accounting for his non-current assets. He does not understand the difference between a revaluation decrement and an impairment loss and has asked why we have different names for the same process. Provide advice to Tom, with relevant references to the Australian Accounting standards in your answer.

Issue 2: Jasper Ltd is a medium sized public company which operates within the manufacturing sector. The assets include a large number of non-current assets such as Plant and Machinery items. The CFO currently prepares the annual financial statements using the Cost model however is considering changing to the Revaluation (fair value) method. In order to assist with his decision, he needs to know the impact that this change will have on the financial statements and reports. The company is in it’s growth stage and wants to continue attracting new investors with its impressive financial results.

Required: In your presentation, discuss the differences between the Cost model and the Revaluation model. In particular, highlight the different impact each model will have on the financial statements. Discuss the effect on each financial statement individually; Balance sheet, Statement of Changes in Equity and Income statement. Also consider any effects on financial analysis and the cost of implementing each model. Each point of discussion needs to address the differences and whether it will encourage new investors to Jasper Ltd. Provide a recommendation in your conclusion as to which model.

Answer 1

Hi,

I am a CMA qualified SAP Consultant from India with certification in IFRS from ACCA. Here I am going to discuss two issues that are related to fixed assets. Mainly on Revaluation, Impairment and two methods of valuing Fixed Assets. i.e., Revaluation model and Cost model.

I would like to consider the issues one by one. First, we have Tom who is confused with the terms “Revaluation decrement” and “Impairment loss”. He does understand both are similar in nature. But he is not clear with the differences. Fixed assets such as machinery, tools, equipment are tangible long-term assets that are not sold in the business, rather used in the production of goods and services.

Fixed assets are recorded in the books at their cost price and are then frequently updated to show their true and fair market value. There are two methods in which this can be done; they are called revaluation and impairment. According to AASB 116 Property, Plant and Equipment paragraph 31 gives provision for Revaluation and 63 deals with Impairment.

Revaluation is a technique used in accounting and finance that helps determine the true and fair market value of a fixed asset. When a revaluation is done, the asset’s recorded value (historical cost value in the ledger) will be adjusted to the market value. The historical values recorded in the books are not accurate since the market value of the asset will fluctuate and may be higher or lower over time. A revaluation will be done to establish the most accurate accounting information regarding the asset’s value. AASB 1041 provides the guidelines for Revaluation of Non-Current Assets.

There may be instances in which a fixed asset loses its value and needs to be written down in the accounting books of the firm. In such an instance, the value will be written down to its true market price or will be sold. An asset that loses its value and needs to be written down is referred to as an Impaired asset. Once an asset has been impaired, there is very little possibility for the asset to be written up; therefore, the asset must be carefully evaluated before it is categorized as an impaired asset. An asset can become impaired for number of reasons, which include becoming obsolete, failing to meet regulatory standards, damages to the asset, changing market conditions, etc. Other company accounts such as a goodwill and accounts receivable can also become impaired. Firms are required to conduct regular tests on asset impairment (especially on goodwill) and any impairment then will be written off. AASB 136 gives the guidelines for Impairment of Assets.

In summary, Impairment and revaluation are terms closely related, with subtle differences. Revaluation and impairment both require the company to evaluate the assets for their true market value, and then take appropriate action in updating the accounting books. The major difference between the two is that a revaluation can be made upwards (to increase the value of the asset to market value) or downwards (to decrease the value). An impairment, on the other hand, only refers to one of the two; a fall in the market value which is then written down.

Now we are moving to the second issue regarding the change from Cost model to Revaluation model. AASB 116 Property, Plant and Equipment provides the provision to use both Cost and Revaluation model to value Fixed Assets.

Under the cost model, the asset is recognized at the net book value (cost less accumulated depreciation). Depreciation is the charge to record the reduction in economic useful life of the asset. These depreciation charges are collected to a separate account named ‘accumulated depreciation account’ and is used to identify the net book value of an asset at any given point of time. The main advantage of using cost model is that there will be no biases in valuation as the cost of a non-current asset is readily available; thus, this is a straightforward calculation. However, this does not provide an accurate worth of a non-current asset since the prices of assets are likely to change with time. This is particularly correct with non-current assets such as property where the prices are constantly increasing.

According to Revaluation method, the non-current asset is carried at a revalued amount less depreciation. To practice this method, the fair value should be measured reliably. This model is also known as ‘mark-to-market’ approach or ‘fair value’ method of asset valuation. If the company cannot derive at a reasonable fair value, the asset should be valued using the cost model. If a revaluation results in an increase in value, it should be credited to other comprehensive income and recorded in equity under the separate reserve named ‘revaluation surplus’. A decrease arising as a result of a revaluation should be recognized as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus.

When we consider the advantages of Revaluation model, it limits a company’s ability to potentially manipulate its reported net income. Sometimes management may purposely arrange certain asset sales, for example, to use gains or losses from the sales to increase or decrease net income as reported at its desired time. Using fair value accounting, gains or losses from any price change for an asset or liability are reported in the period in which they occur. This will be the impact on Income statement by using Revaluation method. Another feature of this model is that it clearly shows the market value and the company has a provision to reverse the value. This cannot be used in Cost model as we keep the value at cost of the asset and the only provision is to use impairment and that cannot be reversed. However, Cost of implementing revaluation model is high as it needs to understand the market while cost of the asset is readily available for cost model.

In conclusion, Investors would encourage Fair value method as they need complete and fair view of the Financial Statements and it restricts the manipulation of the same. As Revaluation surplus is transferred to Other comprehensive income, the value is added to Retained earnings. Therefore, companies should impose restrictions on the distribution of the revaluation surpluses as dividends.